This article is the second in a two-part series on applying the principles of value investing.In part 1 found here my primary focus was on the benefits of investing in fundamentally strong dividend growth stocks when they are out of favor, and therefore, undervalued as a result. In this part 2, I will be turning my attention to determining the fair value of growth stocks. Although the underlying principles of value investing apply, assessing the fair value of a true growth stock differs greatly from valuing a dividend paying company. In both cases, the primary focus of the value investor is on fundamentals first and stock price secondarily.

However, one of the primary differences when valuing a growth stock versus valuing a dividend paying stock is the absolute necessity to focus on the future earnings potential of the company in question. Many of the most famous value investors, Ben Graham for example, believed in valuing a company solely based on historical earnings, and never on future earnings estimates.

Personally, I disagree with that approach, but only in part. When valuing a dividend paying stock, I agree that your primary focus can rationally be placed on the company’s historical achievements. On the other hand, since all investing results do, in fact, occur in future time, I believe that it is important to also have a reasonable perspective of the future growth potential of even a dividend paying company. In the long run, future earnings will determine future market price and the amount of dividend income you will receive.

In contrast to dividend paying stocks, investing in pure growth stocks is primarily based on the opportunity and expectations for above-average future capital appreciation.Since there is no dividend income to soften the blow of stock price volatility, when investing in growth stocks everything is about receiving a higher future price on your investment.Consequently, I believe that it is imperative to place most of your focus on the company’s future growth potential when considering investing in growth stocks.

Growth Stocks Defined

My definition of a growth stock is straightforward and precise. First of all, a growth stock represents the common stock of a company whose business is consistently growing earnings and cash flow at a significantly above-average rate.More precisely, I define a growth stock as a company whose earnings are consistently increasing at a minimum rate of change of earnings growth of 15% or better.

Additionally, I would define a hyper growth stock as one that is growing earnings at a rate of change of 25% or better. Admittedly, although both categories are rare, there are more 15% growers than there are companies growing earnings at 25% or higher. In between these broader gradations of growth are additional growth categories such as a high grower at 20%, etc.

The reason I am offering my precise definition of a growth stock, is because my experience has taught me that modern finance often holds a very cavalier or vague definition of what a growth stock is. Consequently, those engaged in the growth stock versus dividend growth stock debate will often cite studies indicating that dividend stocks outperform growth stocks. However, when I have personally reviewed and analyzed many of those studies, I usually discovered that the researchers were taking great liberties with the definition of a growth stock.

For example, it is commonly asserted that a growth stock is a company with a high P/E ratio. However, a high P/E ratio does not necessarily indicate a high-growth company. In many cases, a high P/E ratio can simply represent a lower growing business that the market is currently significantly overvaluing. On the other hand, it is true that growth stocks tend to carry higher P/E ratio valuations than are typically applied to blue-chip dividend growth stocks. For me to consider a company to be a growth stock, it must also have both a historical and the potential for a high-growth rate of earnings. A high P/E ratio without supporting earnings growth does not make the company a growth stock.

Consequently, many investors hold a vague or even inaccurate view of what a growth stock truly is. Therefore, in the context of this article, I am only discussing the possibility of adding true growth stocks into retirement portfolios based on the definition of a growth stock provided above.

10 Reasons Why Growth Stocks Can Be Appropriate For Retired Investors

Growth stocks are riskier investments than blue-chip dividend paying stocks. However, the potential for extraordinary future returns are often worth the risk. In June of this year I posted an article found here where I listed 10 reasons why growth stocks might be appropriate for retired investors.

I listed those 10 reasons below.However, the above article provides a more comprehensive explanation of the 10 potential benefits of investing in growth stocks.