GARP investing basics
Value investing focuses on the financial fundamentals of a company. It is taught by legendary investor, author and professor Benjamin Graham. With value investing you calculate a stock's intrinsic (or book) value by looking at a company's underlying assets and earnings. Simply stated, if the current share price is below that intrinsic value per share, it's a buy.
Warren Buffett is arguably the most famous value investor. He was a student of Benjamin Graham (as was my grandpa!). And Buffett followed his teacher's value-investing philosophy to become one of the richest people in the world.
Growth investing picks companies that will have above-average growth in their industry or compared to the market as a whole. First, find a growth opportunity that is undervalued. Then ride the price up when the earnings prove you right. However, if earnings fall short of expectations, you are sitting on a much bigger risk for losses. Growth investors hunt for the next Amazon, Apple, Facebook or Google.
And if you can find a stock that passes checks for both value and growth investing, you're in the sweet spot for GARP investing.
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Hunting for growth stocks
Growth is the first word in “growth at a reasonable price.” Start your search for stocks that you think will grow in the future. The most popular metric for growth is PEG, short for price-to-earnings growth.
The price-to-earnings ratio, or P/E, measures the share price compared to the company's income. It shows the multiple of the company's earnings investors are willing to pay for one share of stock. Calculate this ratio by dividing the company's share price by the year's earnings. For example, if a company has a stock price of $10 per share and annual earnings of $2.50 per share, the P/E ratio is 4.0 (10 / 2.50). This 4.0 means investors are willing to pay four times the company's earnings to buy a share of stock.
Compare this ratio to other companies in the same industry to get an idea of what investors expect in the future and if the stock may be overpriced or underpriced.
Savvy investors chart historical earnings to find a trend. Next, they project future earnings (or find a trusted source that does this for them). Now you can calculate a forward-looking PEG by dividing the P/E by the earnings growth. For example, if a company has a P/E of 4.0 and expected growth of 10%, the PEG would be 0.4 (4 / 10). If this number passes your benchmark, the stock goes on to round two.
Some stock charting services also offer GARP specific charts. StockRover, for example, has three GARP screeners. You can find out more about their screeners and other investing tools on our StockRover review.
Add a filter for value investments
Now that growth is taken care of, focus on the “at a reasonable price” part of GARP. Put on your Warren Buffett hat, because we are going to get our hands dirty with value investing metrics.
In addition to the P/E ratio, value investors put a big emphasis on instrinsic or book value. The book value is the total value of a company's net equity. That's assets minus liabilities. The book value per share divides book value by the number of shares outstanding. If the book value per share is higher than the share price, you may have stumbled onto an excellent, low-risk investment opportunity.
Debt-to-equity and free cash flow are two other valuable metrics for value investors. Check out Benjamin Graham's classic book, The Intelligent Investor, or Warren Buffett's annual letters to Berkshire Hathaway shareholders as resources to learn more about value investing.
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Joined at the hip
Buffett famously said that value investing and growth investing are “joined at the hip.” The two approaches use many of the same metrics to decide if a stock is a good buy. But if you want to truly unify the two theories, you fall into the camp of GARP investors.
This portfolio style has some added risk of underperforming in an economy where growth projections don't materialize. And if huge growth arrives like a tidal wave, a GARP portfolio would underperform compared to a pure growth strategy. But if the economy turns sour, the value aspect of the portfolio should act as a buffer that pads you from outsized losses.
There's nothing wrong with calling yourself a GARP investor. If you do it right, you could wind up GARPing yourself to excellent returns.
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