Price-to-earnings (PE) multiples can be a useful tool when it comes to getting a snapshot of a stock’s valuation.

However, relying on this metric alone to identify value or return potential can be unwise.

High growth stocks tend to have PE multiplies well above the market, deterring some investors from owning these stocks.

High growth stocks often have a long-term focus and may not generate positive earnings or cash flows in the short term, making them more vulnerable to rising bond yields.

We are overweight high growth stocks in the Focus Portfolio relative to the ASX 300, with a weighting of 6% relative to the market of 2.3%.

We believe the significant recalibration of valuations over the past 12-18 months is now over after the sharp rise of bond yields since the end of 2021.

We believe high growth stocks, even on high PEs, can offer investors above-market returns. We own a select number of what we classify as “high growth” stocks.

There are a number of reasons why we own these stocks but it tends to boil down to 4 things:

• Exceptional growth potential: we are willing to pay a premium for high growth due to the exceptional earnings potential over the next 5-10 years.
• Conservative analysts - the market always seems conservative on medium term earnings, which leads to upgrades.
• Growth costs are temporary – Investing in growth opportunities can hurt short-term profitability. Removing growth-associated costs help us evaluate a company's current profitability and cash flow potential.
• Exposure to thematics - thematics we believe will provide substantial earnings tailwinds over the medium term.

Elevated spot PEs do not give the whole picture, especially if you believe the earnings story has more legs. There are stocks with earnings that will outgrow their high multiples. The best way to demonstrate this is Xero (XRO).

At the beginning of 2018 (when it started to become profitable), an investor could buy XRO on a 12-month forward PE of ~500x at a price of ~$30. Over time (with some volatility), the forward PE has gradually shifted towards the 100x it is at today.

However, due to a substantially higher E (earnings) in the PE ratio, an investor today buys the stock $92. This is an example of where the E (earnings) has outpaced the derate (PE) of the stock.

As earnings continue to grow over the next 5 years, we believe that the PE will continue to fall. However, we expect the earnings will continue to outpace this decline in the multiple.

XRO has a strong position in Australia and New Zealand with >2 million subscribers representing ~54% penetration of these markets. There remains a very significant runway for growth offshore, particularly in the UK and US. These countries have total addressable markets of 5.5 million and 34.5 million subscribers, while XRO’s penetration remains relatively low at ~16% and ~1%, respectively.

We expect XRO to grow its market share offshore over the coming years on the back of its significant investments into sales and marketing. This should translate to strong revenue growth and expanding margins given the company’s significant operating leverage. We think this will see XRO quickly become a very profitable, high return-on-invested capital business.

High growth stocks can present a challenge for analysts when it comes to forecasting future earnings potential. Analysts may underestimate the growth potential of these companies.

High growth companies may invest heavily in research and development, marketing, and other areas that can negatively impact earnings in the short term. However, they may lead to significant earnings growth in the future.

This can result in analysts being too conservative in their earnings forecasts. This may create an opportunity for investors to buy the stock at a lower valuation than its growth potential warrants.

When we evaluate growth stocks, we strip out growth-associated costs when evaluating a company to get a clearer picture of its underlying profitability and cash flow.

Growth-associated costs refer to the expenses a company incurs when investing in new products, services, markets, or other growth initiatives. These costs may include research and development, marketing and advertising, and capital expenditures.

While these costs are necessary for a company to pursue growth opportunities and increase its future earnings potential, they can also have a negative impact on a company's current profitability and cash flow. By stripping out growth-associated costs, an investor can better understand the core profitability of a company's existing business operations and assess its ability to generate cash flow from its current operations.

This can be particularly relevant for high growth companies, which may be investing heavily in growth initiatives and have higher growth-associated costs compared to more mature companies.

Again, we will use XRO as an example. As the company builds more scale, we think there will be scope for the business to wind back its high rate of investment into marketing and product development (currently representing >80% of OPEX and ~70% of revenues) in line with other more mature software businesses (where total OPEX typically represents ~50% of revenues).

The results give us a company that can operate on a 25% NPAT margin. Taking the expected revenue in FY25 (A$1.8bn), results in an EPS of $3 and an implied PE of ~30x, as shown in figure 6. This gives us comfort that if XRO decided to focus on its existing business operations rather than growth, it would trade on a “reasonable” PE for a stock with the potential for high ROIC and strong cash flow.

Pleasingly, XRO has already made significant strides towards reducing its cost base and “driving disciplined growth” with an update in March this year highlighting the company’s increased focus on cost discipline which will improve the company’s profitability materially and see its operating expense to revenue ratio fall to ~75% in FY24 (compared to 84% in FY22).