Personal Finance: Understanding The Stock Market

Growth stocks are the shares of companies able to increase their earnings per share at a greater rate than average. Shares in such companies can be one of the most rewarding of stock market investments, with shareholders securing significant capital gains in the long term as earnings per share and share price are umbilically linked.

Earnings per share is a straightforward concept. It is simply the after- tax profits divided by the number of shares issued. If a company manages to sustain an annual 15 per cent growth, it would double earnings over a five-year period.

Naturally, investors are interested in the future as opposed to the past. Optimistic views in the chairman's statement found in the most recent annual accounts point to history repeating itself. Another good sign is the company's policy towards dividends. A record of an increasing rate of dividend is good, but a fall in the rate of increase or simply maintaining the previous level can be a warning signal.

While a company's above-average progress is an indication of good management, it also suggests it has a strong competitive advantage which makes it difficult for others to improve on or copy.

Companies with brand names that have long been household names are in a strong position to grow. Similarly companies which have patents on products in great demand can earn shareholders a fortune.

Companies' published accounts offer invaluable information. Increasing profits need to be reflected in growing cash balances, not in higher stock levels or fixed assets.

Check that the net operating cash flow is at least the same as, but preferably more than, the net operating profits. Truly great growth stocks also have little or no balance sheet debt. Seek companies whose debt is less than 50 per cent of net assets.

The engine that drives a company's share price is earnings. One of the leading investment yardsticks is the price/earnings (p/e) ratio. It is the company's share price divided by its after-tax earnings per share. In other words is the number of years' earnings needed to equal the current share price.

Investors will pay more for a share if they think a company's earnings are going to rise quickly. Essentially the ratio reveals how highly investors value a company's prospective earnings.

Generally, a high p/e denotes a growth company, while a low p/e ratio is a sign of inertia and risk. The p/e is shown daily on The Independent's Shares page.

-John Andrew