IQE(LSE: IQE) has been one of the market's star performers over the past year. Since mid-January 2017, the shares have gained more than 230%, outpacing all of the UK's major indexes.
Unfortunately, over the past three months, shares in the company have struggled as investors have become concerned about the group's lofty valuation. At the time of writing the shares are trading at a forward P/E of 32.8.
Betting on growth
For a high-growth company like IQE, this multiple is easy to justify. The City is currently expecting it to report earnings per share growth of 28.5% for 2017 implying a PEG ratio of 1.2. A PEG ratio of one or less signifies that the shares offer growth at a reasonable price based on growth and valuation estimates. For 2018, analysts are projecting year-on-year earnings growth of 31.6%. If the firm hits this target, the shares are trading at a 2018 P/E of 29.1 and PEG ratio of 0.7.
So if IQE hit its growth targets for the next two years, then the shares look appropriately priced. However, a lot could go wrong over the next two or three years and if IQE fails to live up to expectations, then I believe investors could end up nursing heavy losses as the company's valuation falls back to earth.
With this being the case, I believe that small-cap Fairfx(LSE: FFX) might be a better buy for growth hunters.
Over the past five years, Fairfx has been struggling to build its business to scale. Even though revenue has grown at a rate of approximately 36% per annum since 2011, the firm has struggled to break even.
City analysts expect this to change in the next two years and are expecting the financial services company to report a net profit of £8.1m for 2018 and earnings per share of 5.4p on revenues of £2.5bn.
The firm is already well on the way to this target. Today it reported that revenues for 2017 are on track to exceed £1.1bn, up 39% year-on-year and both revenues and profits are expected to be "ahead of market expectations for FY17."
2018 is set to be an even better year for the firm. At the end of December, it was given full membership status with Mastercard, allowing it to "issue Mastercard branded cards, initially across Europe but with other regions to follow." This will allow the company to create third-party card programmes in-house producing cost savings as well as streamlining its services.
With Mastercard on-side, management will also be able to accelerate the growth of CardOneBanking, which was acquired last year. CardOne offers a simple banking service for customers with no credit checks and no branches. So far, over 80,000 customers have signed up for the service.
As Fairfx continues to build on its existing business of international currency payments and complements this growth with other financial services, the group should be able to keep expanding, and margins should improve, leading to further profit growth.
Unlike IQE, you don't have to pay a premium for this growth. The shares are currently trading at a forward P/E of 14.2, which I believe undervalues Fairfx and its growth potential.
Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.