Buying Risky Growth and an Explanation for Returns for Trading on P/E Ratios

Fundamental investors warn about buying growth, for growth is risky. This paper lays out an approach for buying growth with the warning in mind. It first identifies the value-adding growth that an investor should pay for, then lays out a scheme for identifying how much the market is asking the investor to pay for that growth. That is the price to be challenged: Is the market pricing growth correctly? The paper lays out a fundamental analysis to answer that question. With some exceptions, the answer is yes: The market typically discounts expected growth for risk appropriately. The findings come with a caution about buying P/E where “value” investors see returns. Buying P/E is risky and the paper provides an explanation: P/E ratios imbed expected earnings growth but also the risk to growth. They are discounted for that risk so returns to buying P/E are typically just returns to risk.  

Stephen Penman is the George O. May Professor in the Graduate School of Business, Columbia University