In my view, the FTSE 100 and the FTSE 250 have some terrific growth stocks. Three of the best are Croda International, Diploma, and Rightmove.
Are any of these worth investing in at today’s prices? To find out, I look to Warren Buffett’s advice.
Buffett’s approach
At the 2000 Berkshire Hathaway Annual Shareholder meeting, Buffett said the following about growth stocks:
Let’s just take a company that has marvellous prospects, is paying you nothing now, and you buy it at a valuation of about $500bn. Now if you feel that 10% is the appropriate rate of return – and you can pick the figure – that means that if it pays you nothing this year, but starts paying next year, it has to be able to pay you $55bn in perpetuity each year. But if it’s not going to pay until the third year, then it has to pay you $60.5bn in perpetuity to justify the present price.
According to Buffett, whether a stock is a good investment or not comes down to the cash it will produce. And the longer it takes for the company to produce the cash, the more it has to produce to justify its current share price.
With interest rates forecast to reach 4%, I think it’s reasonable to require a 7% return to justify the risk of investing in stocks. So let’s see how Croda, Diploma, and Rightmove shape up using Warren Buffett’s approach.
Valuing growth stocks
Croda shares have fallen by 33% since the beginning of the year. As a result, the company now has a market cap of £9.2bn.
At these prices, a 7% annual return implies £644m in cash each year starting immediately. Croda’s annual free cash flow is currently around £145m.
Diploma has a market cap of just under £3bn. The company’s share price is now around 30% lower than it was since the start of the year.
To justify an investment at these prices Diploma needs to generate £210m in free cash annually. Over the last 12 months, Diploma produced £107m in free cash.
Lastly, Rightmove shares trade at a price implying a market cap of just under £5bn. That’s following a 25% decline in the company’s share price since January.
A 7% annual return implies free cash generation of £350bn annually. Last year, Rightmove’s free cash flow came in at £191m.
2 growth stocks I’d buy today
I think that Croda shares look expensive at current prices. Diploma and Rightmove, on the other hand, look attractive to me.
A 7% average return implies 30% annual growth in free cash flow for Croda. That seems like a lot to me and I’m not prepared to invest on that basis.
For Diploma and Rightmove, the equation looks much more favourable. Free cash flow growth of 10%-15% annually would see each company generate a return of over 7% on average.
In my view, this kind of growth might well be realistic. As a result, I’d be happy buying either Diploma or Rightmove shares at today’s prices for my portfolio.