How I’m picking 2 cheap growth stocks using Warren Buffett’s method

By looking at P/E ratios and earnings growth, Warren Buffett’s techniques lead me to two cheap growth stocks.

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Warren Buffett is perhaps the most successful investor of all time. Worth in excess of $100bn, Buffett acquired about 99% of this wealth over the age of 50. His secret? To buy cheap growth stocks and hold them for the long term. After all, time is his greatest asset. In 1999, Buffett advised investors to “start early … I started building this little snowball at the top of a very long hill”. I’m now following two of his techniques to find cheap growth stocks. These are the price-to-earnings (P/E) ratio and compound annual earnings growth. Let’s take a closer look.

The techniques of Warren Buffett

A trailing P/E ratio is calculated by dividing the share price by the earnings. For a forward P/E ratio, we look instead at forecast earnings. The result, compared with competitor companies, may indicate if the firm is under- or overvalued. 

By way of example, one of Warren Buffett’s recent acquisitions is gaming company Activision Blizzard. This business has a trailing P/E of 23.67 and a forward P/E of 22.37. Compared to a major competitor, Playtika, Buffett’s purchase may be a bargain. Playtika has respective ratios of 27.47 and 23.75.

Earnings-per-share (EPS) is another important metric for Warren Buffett. This essentially tells investors how profitable a company is per outstanding share. I have previously covered the formula for calculating compound annual EPS growth rates elsewhere, but it measures the constant rate of return over a given time period.

One of Buffett’s largest holdings, Coca-Cola, has had a compound annual EPS growth rate of 10.6% over the last three calendar years. He will also be checking that management is reinvesting its ‘retained earnings’ in a responsible way.    

Two companies that fit the bill

Based on all this, the first business I’m looking at is Pan African Resources, a gold miner operating in sub-Saharan Africa. Its compound annual EPS growth rate of 8.3% is strong enough for me to look deeper. The company is also expanding, internally funding the extension of the life of its Evander Mine by 13 years in the past year. It’s worth noting, however, that any pandemic resurgence could halt mining operations.

Furthermore, its trailing P/E is just 7.02. This is much lower than major competitor Petropavlovsk that has a trailing P/E of 41.49. With a current share price of 22.4p, I find Pan African Resources very attractive based on Warren Buffett’s principles. 

The second business is Renew Holdings, a support services firm specialising in construction and engineering. Its compound annual EPS growth rate over the past five calendar years is 6.3%. While this is not as high as Pan African Resources, it is certainly competitive and consistent. However, the firm posted net debt of £13.7m for the 12 months to 30 September 2021, down from a net cash position of £300,000 in the previous year. 

Its forward P/E ratio, of 12.41 at a current price of 680p, is significantly lower than Balfour Beatty‘s. The latter is a competitor and has a forward P/E ratio of 26.07. Renew Holdings recently bought J Browne for £29.5m and this provides greater exposure to the water business. New clients include Thames Water and Southern Water. It appears Renew is putting its earnings to good work.  

I’ve always found Warren Buffett’s techniques useful. I will buy both Pan African Resources and Renew Holdings without delay, acquiring two cheap growth stocks in the process.  

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Andrew Woods 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.

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