One of the biggest challenges when investing in growth stocks is deciding when it makes sense to pay a premium for future growth.
Personally, I only consider paying up front only when the firm is delivering strong growth with improving profitability. Today I'm looking at two growth stocks to see if either meets my buying criteria.
This could be a turning point
Shares of IT services and medical device manufacturer BATM Advanced Communications(LSE: BVC) dipped slightly today, despite the group issuing a fairly solid set of 2017 results.
Revenue at the Israeli firm rose by 18.5% to $107.1m last year. The group converted last year's operating loss of $302k into an operating profit of $4.2m.
A breakdown of the figures shows that BATM's IT networking and cyber security division made a modest profit of $0.9m on sales of $49.4m last year, after reporting a $2.2m loss one year earlier.
However, the group's Bio-Medical division, which makes laboratory diagnostic products, saw its operating loss increase from $0.3m to $1.1m, despite sales rising from $51.6m to $57.4m.
So where did the $4.2m operating profit come from? It turns out that the vast majority was generated by the sale of a freehold building -- obviously a gain that can't be repeated.
The true picture
According to today's figure, the group's underlying operating profit was just $0.1m last year. Although this is an improvement on the $2.2m operating loss reported last year, it doesn't appeal to me.
Analysts expect sales growth of just 4% this year and are forecasting a fall in adjusted earnings. This group still seems to be struggling to turn a profit on revenue of more than $100m. With the stock trading on a massive 358 times 2018 forecast earnings, I'd take advantage of recent gains and sell.
A proven performer
If you're looking for a good example of a business where it might be worth paying extra for future growth, you might want to consider IT infrastructure group Softcat(LSE: SCT).
This £1.2bn business was founded in 1987 but only floated in 2015, since when its shares have risen by 128%. One reason for this is probably the firm's strong profit growth. After-tax profit has risen from £20m in 2013 to £40m in 2017.
Since the group's flotation, earnings per share have risen from 15.8p to 20.2p. An increase of 15% is expected for the current year, putting the stock on a forecast P/E of 26.
Although this is quite expensive, it's worth noting that the company's earnings have been consistently backed by free cash flow in recent years. This is reflected in the debt-free balance sheet and a generous dividend. The total payout last year was 19.6p per share -- almost 100% of earnings.
Although 13.5p of this payout was a special dividend, analysts expect a similar payout of 18.4p per share this year, giving a prospective yield of 3.1%.
Too good to be true?
This is an extremely profitable business. Softcat's return on capital employed was 56% last year and has averaged 50% since 2013. This indicates that the company can generate very high levels of profit from its assets.
Assuming the markets in which it operates are big enough, I don't see why Softcat can't continue to expand. In my view, the shares remain a growth buy.
One growth stock I'd buy today
I believe Softcat could be a good buy at current levels. But I'd urge you to consider the company featured in A Top Growth Share From The Motley Fool before you make any investment decisions.
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Roland Head has no position in any of the shares 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.