Growth stocks can make you rich! By Clifton Dsilva (Edit 1 May 2007)

It must have been drilled into your head by now that equity is the best investment. Invest in shares and you could make great returns. That's true. What's in a share? Money! An investment in debt (bonds, fixed deposits, etc) provides a fixed rate of return. If it is eight percent per annum and you invest Rs. 1 lakh, you will get Rs. 8,000/- per annum. But if you invest in the right stock, the return could be substantial. In fact, an investment of Rs. 1 lakh could grow to Rs. 2 lakhs or more in a year. Did you know that if you had invested Rs. 5,000/- in the public issue of Colgate in 1978, by 1994, your investment would have been worth Rs. 43,52,000/-. Make money with shares What is not true is the belief that each and every stock will give you the same return. Investing in any and every stock that comes your way won't leave you smiling. Equities, as a form of investment, offer the best rate of return only if you have made your investments wisely and in growth oriented companies. Which brings us to the question: How do you identify which company is on the growth path? Let me use a simple example to try and explain this. You start with cost and profit Company XYZ is capable of producing (has a production capacity of) 10,000 motorcycles. It utilizes 100 percent of its production capacity. That means it produces 10,000 motorcycles. If it produced less than that, say 9,500 motorcycles, it would be operating below its capacity. Each motorcycle is sold for Rs. 30,000/- Total turnover = Rs. 30,000 x 10,000 = Rs. 30 crore. Now, from this turnover, the company will minus its cost and taxes to arrive at its net profit. Let's say the net profit amounts to 10 percent of turnover. This will amount to Rs 3 crore. Then, you look at its equity base Assume the company had Rs. 5 crore worth of shares (50 lakh shares x Rs. 10/- per share). The net profit of Rs. 3 crore on its existing equity base of Rs. 5 crore translates into an earning of Rs. 6/- per share. Let's say the market price of each share is Rs.50/-. The price earnings ratio is 8.33. How did I arrive at this figure? You take the market price of the share (Rs. 50/-) and divide it by the earnings per share (Rs. 6/-). This gives you 8.33. You buy the shares When you buy the shares, it costs you Rs. 50/- per share. You buy 500 shares and pay Rs. 25,000/- for them. The demand for motorcycles is growing. Now, the company decides to produce more motorcycles. To do this, it has to expand its facilities. So it begins to borrow from financial institutions and banks. Over the next five years, the company hikes its production capacity from 10,000 motorcycles to 50,000 motorcycles. This increase in its facilities was possible because of the money it borrowed. In simple terms, when you purchased the shares five years ago, you were the part owner of a company with a production capacity of 10,000 units. Five years later, you are the part owner of a company with a production capacity of 50,000 units without any further investment on your part. In other words, your investment has grown five times over a period of five years or 100 percent annually. How would that work out in money terms? The price of each motorcycle has gone up and the company is now selling motorcycles at the rate of Rs. 40,000/- per unit. Its production capacity is now 50,000 units. So it makes and sells 50,000 motorcycles (operating at 100 percent of its production capacity). The turnover at full capacity amounts to Rs. 200 crore (50,000 motorcycles x Rs. 40,000/-). With a net profit margin of 10 percent, the net profit works out to Rs. 20 crore. So, now, the net profit of Rs. 20 crore on its existing equity base of Rs 5 crore translates into an earning of Rs. 40/- per share. If the same price earning multiple of 8.33 is applied, the stock price would quote at Rs. 333/-. Now, multiply your 500 shares with the market price of Rs. 333/- and your investment value works out to Rs. 1,66,500 compared to the original investment of Rs. 25,000/-. This may not be the end. Growth could continue faster in the years ahead. This example is just to prove the powerful returns equities can generate if the selection is proper. Surely equity can give the highest return. But it is also the riskiest form of investment, since no return is guaranteed. A young investor can afford to take a higher level of risk, whereas an older investor, who is on the brink of retirement or has already retired, cannot afford to take unnecessary risks. A young individual can place as much as 80 percent of his investments in equity. In the case of the older investor, the debt component will be higher as the capacity for risk is limited. Clifton DeSilva is the Chairman & Managing Director, Altina Securities Pvt. Ltd. Member National Stock Exchange of India