Growth Investing: Pay Up for Faster Earnings

Key Takeaways

• Growth investing accepts a higher current multiple in exchange for a faster future earnings stream that can justify the price over time.
• A software company growing at 25% with a 22x P/E has a PEG of 0.88, cheaper than a stagnant industrial at 15x with 3% growth.
• The most common mistake is extrapolating early-stage growth indefinitely, most growth rates decay faster than models assume.
• Growth investing belongs in a portfolio as a complement to value, capturing companies that will compound earnings for many years.

What It Is

A growth investor accepts a higher current valuation in exchange for a higher future earnings stream. Where a value investor looks for a mispriced present, a growth investor looks for a mispriced future. The two styles are often painted as opposites, but both ultimately try to buy more cash flow than the price implies.

Fisher founded Fisher & Co in 1931 and ran it until 1999. His signature idea was that identifying a small set of exceptional businesses and holding them for decades produced far better results than trading in and out of cheap stocks. Warren Buffett has repeatedly credited Fisher as a major influence alongside Benjamin Graham.

The Intuition

Earnings grow, then compound. A company that reinvests capital at 20 percent and keeps doing so for ten years turns one dollar of earnings into roughly six. A company stuck at 3 percent barely keeps up with inflation. If you are right about which company is which, a high current multiple can still be cheap on a ten-year view.

The catch is that the market already knows growth matters. It pays up front. Most of the return from growth investing therefore depends on growth being higher, longer, or more durable than the consensus assumes. Getting the growth rate right matters, but getting the duration of growth right matters more.

How It Works

Fisher's scuttlebutt method asked investors to build a picture of a company by talking to its customers, suppliers, former employees, and competitors rather than reading only the financials. The goal was to spot qualitative edges, such as an unusually capable management team or a product cycle that had years left to run.

Modern growth investors combine that qualitative work with three quantitative screens:

• Revenue growth above a threshold, often 10 to 20 percent year on year
• High and stable return on invested capital (ROIC), suggesting reinvestment compounds rather than destroys value
• A valuation sanity check, usually the price/earnings to growth (PEG) ratio

PEG = (P/E ratio) / (expected earnings growth rate in %)

A PEG of 1.0 means valuation is roughly proportional to growth. Peter Lynch, who ran Fidelity Magellan from 1977 to 1990 and popularised the growth at a reasonable price (GARP) hybrid, typically looked for earnings growth of 15 to 25 percent paired with a PEG at or below 1.0. PEG is imperfect because both inputs can be manipulated, but it is a useful first filter.

Worked Example

Consider a software company growing revenue 25 percent per year with 80 percent gross margins and a 22x trailing P/E. At first glance 22x looks demanding. Divide by the 25 percent growth rate and PEG is 0.88, which is cheaper on a growth-adjusted basis than a stagnant industrial at 15x with 3 percent growth (PEG 5.0).

If the software business can sustain 20 percent plus growth for five more years, earnings roughly triple. Even if the P/E compresses from 22x to 15x as growth matures, the share price still compounds at a healthy clip. That is the growth thesis in miniature. The risk is that competition, saturation, or a product miss cuts the growth rate in half, in which case the multiple contracts faster than earnings can catch up.

Common Mistakes

1. Paying any price for growth. The 1999-2000 tech bubble and the 2020-2021 pandemic rerate both ended the same way. When valuation becomes irrelevant to the thesis, it usually becomes extremely relevant six months later. A durable growth story still needs a price you would defend on paper.

2. Confusing revenue growth with value creation. A company that grows revenue 30 percent while burning cash and diluting shareholders can destroy value even as headlines look great. Look at ROIC, free cash flow, and share-count trend, not only the top line.

3. Extrapolating early-stage growth indefinitely. Most growth rates fade. Pricing a stock as if 30 percent growth lasts ten years builds in a forecast the historical base rate does not support. Base cases that assume decay are more reliable than straight lines.

4. Ignoring management quality. Fisher's scuttlebutt work was mostly about judging the people running the business. Capable, incentive-aligned managers compound growth. Empire-building managers destroy it even when the market is growing.

5. Selling too early on a valuation wobble. Fisher wrote that the best time to sell a great compounder was "almost never." Rotating out of a quality grower because its multiple ran hot for a quarter often forfeits the multi-year compounding that justified owning it in the first place.

Frequently Asked Questions

Q: What is growth investing in simple terms? Growth investing means paying a higher price today for companies whose earnings are expected to grow faster than average. The bet is that future compounding will eventually make that high price look cheap.

Q: How does growth investing affect investment decisions? It shifts focus from current cheapness to future earnings power. You spend more time evaluating reinvestment rates, competitive moats, and management quality, and less time comparing current P/E ratios to peers.

Q: What is a real-world example of growth investing? The article's software example trades at 22x earnings with 25% growth, giving a PEG of 0.88. Even though the multiple looks high versus a slow industrial at 15x, the growth investor sees the software name as cheaper on a growth-adjusted basis.

Q: How can investors use growth investing in their portfolio? Screen for revenue growth above 15%, stable or rising ROIC, and PEG at or below 1.0. Use Fisher's scuttlebutt approach to validate qualitative advantages before buying. Size positions for multi-year holds rather than quarterly rebalancing.

Q: How is growth investing different from momentum investing? Growth investing is fundamentals-driven, it buys companies with superior earnings power and holds them as earnings compound. Momentum investing is price-driven, it buys recent winners regardless of fundamentals and holds only until the price trend reverses.

Sources

1. Fisher, P. A. (1958). Common Stocks and Uncommon Profits. Harper & Brothers. https://www.goodreads.com/book/show/25574.Common_Stocks_and_Uncommon_Profits_and_Other_Writings
2. Quartr. "The Timeless Investment Wisdom of Philip Fisher." https://quartr.com/insights/investment-strategy/the-timeless-investment-wisdom-of-philip-fisher
3. Nasdaq. "Growth Investing with a Value Twist." https://www.nasdaq.com/articles/growth-investing-with-a-value-twist

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.