Investors should identify a growth stock which is undervalued and then gain when earnings rise. So, buy stocks when the P/E ratio is lower than the rate at which earnings per share can grow in the future
The term ‘GARP’ stands for ‘growth at a reasonable price’ and it is a stock selection strategy which is widely used by investors across the world. Under value investing strategy, investors look for companies whose current market price is below their intrinsic value. Growth investing focuses on smaller or newer firms with an above industry average growth prospect. GARP combines the value and growth investing strategy into a single set of investment philosophy.
Mechanics of GARP investing
Value investing focuses on the financial fundamentals of a company but growth investing picks companies that have above-average growth in their industry or compared to the market as a whole. As an investor, one should identify a growth stock which is undervalued and then ride the price up when the earnings prove you right. The salient feature of this method of stock selection is to avoid the extremes of the growth and value styles by finding reasonably priced growth-oriented stocks.
Metrics to look for
One should combine the value and growth approaches and add a numerical slant. Investors look for companies with solid growth prospects and current share prices that do not reflect the intrinsic value of the business. So they are getting a double play as earnings increase and the price/earnings (P/E) ratios at which those earnings are valued also increases.
One of the most common metrics under the GARP approach is to buy stocks when the P/E ratio is lower than the rate at which earnings per share can grow in the future. As the company’s earnings per share grow, the P/E ratio will fall if the share price remains constant. Since fast-growing companies normally can sustain high P/Es, the investor is buying stocks that will be cheap tomorrow if the growth occurs as expected.
Another metric to look for is the price earnings growth (PEG) ratio. The ideal PEG ratio should be one or less than one. Let us assume a share is trading at Rs 50 with earnings per share (EPS) Rs 5, which is expected to grow at 15% over the next one year. So, P/E ratio (current market price / earnings per share)= Rs 50/Rs 5 = 10 and PEG ratio (P/E ratio / annual EPS growth) is = 10/15 = 0.66. Thus PEG which is less than 1, makes this company a good candidate for GARP.
Growth stocks could be more volatile and may fall as fast as they climb. These growth stocks could form bubbles so investors who bought in the later part of the rally might lose significant amounts. Value stocks could take a long time to see share price appreciation. These stocks may be fundamentally strong but the stock price may not reflect this and it may take a long period before the markets recognise this share. GARP shares demonstrate both good earnings and growth potential but the stock market has not overpriced these shares till date.
To conclude, under this approach do not simply balance your portfolio with an equal number of growth and value shares. Instead, ensure that each share has the characteristics of both.
P Saravanan is professor of finance & accounting, IIM Tiruchirappalli