Growing companies that have been increasing in price are often seen as great opportunities by investors.  Up front, the argument makes a lot of sense; the company is growing so why not jump on the wagon and grow with it? A quick look at the mathematics that drive stock returns illustrates the flaws in this logic.

The return that an investor will receive from a stock that does not pay a dividend is characterized by the growth in its earnings per share (EPS), and the change in its price to earnings ratio (P/E).

From this simple mathematical relationship it is easy to see that a large increase in EPS will result in a large return for shareholders; the caveat comes from the effects of a changing P/E. When a company is growing rapidly and investors are excited about the expected growth, these expectations are included in the market price of the stock at that time. This means that due to expectations, the price increases before the actual earnings increase. Growth companies will have a high P/E. Although the market price is high relative to the actual trailing earnings, investors are willing to pay a premium to hold the stock because they are expecting the growth to continue into the future. The problem lies in the fact that when an investor has identified a growth stock, the P/E is already inflated by definition; the market price already includes the expectations for future growth. Even as earnings continue to increase, it is much more difficult for the P/E to increase at the same pace as the earnings that are being realized have already been priced in. So even though the company is continuing to grow as expected, investors will not see their investment follow the same path. The moral of the story here is that although growing companies look like they will offer great returns for investors, it is important to assess how much is being paid to partake in the growth. If the premium at the time of purchase (P/E) is too high, holding period returns will likely be diminished.

Armed with this knowledge, one of the biggest challenges is to overcome the psychology of investing. It seems like a safe bet to invest in the companies that dominate the news headlines, and everyone loves to brag about their Google or Apple shares around the water cooler; the idea of saying that you have invested in some little known company that just went through a management change doesn’t evoke the same emotions. As much fun as it is to observe a good growth story, it is important to remember that all available information and expectations have already been priced in by the market.