How does Growth at a Reasonable Price (GARP) technique work?
Growth and value combined uncovers sustainable cash equity investments
Growth and value investing do not have to be diametrically opposed. The Growth at a Reasonable Price (GARP) technique unites the two styles to avoid the extremes of either growth or value investing; this means that you as a GARP investor would look to growth-oriented stocks with relatively low valuation multiples in regular market conditions.
By combining both growth and value investing tenants, GARP investors seek companies that are balanced between consistently strong earnings growth and those that trade below their intrinsic price value.
These stocks are considered outperformers in terms of growth rates and future potential but are deemed undervalued or bargains based on their valuation metrics. This hybrid approach also helps to eliminate extremes on either side, for example, companies with unconvincingly high growth rates and bloated valuations or companies with extremely low growth rates and deeply discounted valuations.
- Balanced approach to growth and value investing.
- You can find stocks at reasonable price that have been largely overlooked.
- Eliminates the extremes sides of both growth and value stocks.
- You must conduct careful and detailed financial analysis of stocks.
- It's a long-term strategy not suitable for day traders who want quick returns.
- GARP stocks can underperform growth stocks in a growth market and underperform value stocks in a value market.
Screening for GARP stocks
GARP investors screening their investable universe for stocks with growth rates (both actual and projected on both a quarterly and annual basis) that are above the median for the market, while also excluding valuations that are below the median for the market. This helps to uncover stocks that are trading at 'reasonable' prices.
The GARP strategy was popularized by legendary fund manager Peter Lynch, who became a Wall Street legend by employing GARP to produce 29% average annual returns over a 13-year period (1977-1990) as manager of the Fidelity Magellan fund.
Your ability to screen for suitable stocks is key to achieving success through GARP. It is imperative to conduct a careful and intensive analysis of a company's financial statements, projected growth in earnings and valuation using the aforementioned metrics. By doing so, you could land yourself the ideal stock that both growth and value investors have overlooked.
Calculating cash equity value
A fundamental formula for identifying GARP is the price-to-earnings-growth ratio (PEG). The ratio divides a company's current P/E ratio by the earnings growth rate and is intended to measure the balance between growth and valuation. This ratio takes long-term earnings growth rates into consideration, which is vital to the concept of GARP.
To implement this technique, you would seek out stocks that have a PEG no higher than 1 and, in most cases, closer to 0.5. If a stock has a PEG of less than 1, that indicates its price is lower than it 'should' be given its earnings growth, making it ideal for GARP investing.
For example: If company XYZ, has a P/E ratio of 15 and earnings growing at 25%; to calculate its PEG: 15 ÷ 25 = 0.6. With a PEG of 0.6, company XYZ would be considered an appropriate candidate for inclusions in a GARP strategy.
Companies with a lower price-to-book (P/B) ratio also tend to be favoured in the GARP investing approach. P/B ratio is calculated by dividing a stock's current share price by the book-value-per-share of the stock.
Companies with a P/B ratio below the sector average are favoured under the GARP strategy as this indicates larger profit potential in the event of a market correction, which advocates claim results in pricing the stock more accurately.
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