Investing in growth shares can be very lucrative. But it sometimes also turns into a financial horror story. Here is how I try to value growth shares in a way that helps me decide whether they might be a good addition to my portfolio.
How to value shares
First I think it is worth remembering that a share is a share.
Whether I see a particular investment opportunity as a growth share or income share, my ultimate aim is the same. I want it to produce more value for me in future than I pay for it today, discounting for the fact that as a long-term investor my money will often be locked up for years in the investment.
That value might come from an increase in share price, dividend payments, or a combination of both. In the case of growth shares, many (though not all) invest their profits in growing the business rather than paying dividends. So often it is the opportunity for share price appreciation I consider when weighing up whether to add growth shares to my portfolio.
If I showed you a trick of turning a £10 note into a pound coin, you might be impressed. But if the £10 note belonged to you, you would likely not be very happy.
Yet that is exactly what many people do when investing in growth shares – and on a far bigger scale. The need to invest for growth, especially if revenues remain small or non-existent, means that companies burn through cash and rack up large losses rather than making profits.
That is why I do not own shares in battery companies at this point, even though I see the long-term potential in the business sector. Whether it is Ilika Power (down 56% in a year) or AFC Energy (70% lower over the past 12 months), burning cash is the opposite of what I want a company to do for me to buy its shares.
However, many growth companies are at an early stage in their development. It may be necessary to lose money for a period of time to grow their business. Just because a company is losing money hand over fist today does not necessarily mean that it might not be highly profitable in future.
However, I am willing to forego some possible returns by not getting into a share very early, in order to increase my likelihood of reward.
On a practical level that means that when hunting for growth shares to buy, I try to look either for evidence of existing profitability or at least a clear path to profitability. For example, that could be reflected in a trend of strong sales growth from a sizeable base combined with a trend of sharply declining losses. Simply having a promising business idea is not enough!
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C Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.