Investing in growth stocks can be a great way to build wealth over time, but it can also be risky. High valuation multiples can mean that tiny disruptions will have huge impacts.

Anyone starting to invest needs to think about how to analyze growth shares. The good news is that they are not much different from other stocks.

Development and value

All investors should be interested in how much money a company will earn in the future. But the main difference is when the profits start showing up.

Value stocks are shares of companies whose earnings currently (or in the near future) justify the current share price. For growth stocks, they are further into the future.

This means that growth stocks carry some risk. If profits don’t materialize as expected, the investment could end badly, leaving someone with inflated stock prices.

As a result, a key question for growth investors is how long a company can grow its earnings. This question has two parts.

The first is the speed of the company’s expansion into up-to-date product lines, locations, or geographic areas. The second is what kind of growth it can generate once it reaches that point.

These are not always basic questions. But let’s look at an example to illustrate the points in action.

Top FTSE 100 stocks

Halma (LSE:HLMA) is one of the best performers FTSE100 economic growth over the last 10 years. This is a collection of specialist technology companies focused on security.

The main source of the company’s growth are acquisitions of other enterprises. But it can’t do this forever, so investors need to think about how long this can go on.

Halma is vast by British standards, but should be able to operate acquisitions to accelerate its growth for some time. However, there is a risk that the company may overpay for its activities.

The second question is what happens when these opportunities become rarer. And that’s why investors pay special attention to a metric called “organic revenue growth.”

It measures how much revenue grows in a company’s existing businesses. Since 2020, this percentage has consistently exceeded 10% per year, which is impressive.

Based on the company’s adjusted multiples, Halma’s share price trades at a price-to-earnings (P/E) ratio of 34. That’s high by UK standards, but investors have to wonder whether it’s justified.

Conclusions from investing

Halma’s stock looks costly, but there’s reason to believe it’s not. If the company grows at a rate of 10% per year, the P/E ratio will drop to 20 within five years.

This is the organic growth rate over the last five years. And while there are no guarantees, the calculations do not take into account margin growth or acquisitions.

That being said, I think the estimates may be quite conservative. Investors may therefore want to take a closer look at what appear to be costly stocks.

Ultimately, all investments are aimed at the company’s future profits. However, growth investors typically expect patience in exchange for greater rewards down the line.

Investors need to be wary of companies that can’t live up to their billing. However, if all goes well, growth stocks can create enormous wealth over time.