GoogleTwo growth stocks reported in the last two days: Google (GOOG) and Chipotle (CMG), with the former falling and the latter rising. Other than being growth names, these companies have little in common; one is tech, the other fast casual dining. One has been a multi-billion dollar giant for well over a decade and is becoming mature, the other is quite new and still expanding. But they both have one thing in common: they are priced for multiple expansion.

To understand just how growth stocks work, you need to look deeper than their “potential”. Just seeing the potential is really only seeing the surface of a company, and this naive reasoning is what gets a lot of retail investors suckered into buying overly expensive companies after they have already exploded in value.

A more intelligent approach to growth stocks involves understanding what their P/E ratio reflects. The price-to-earnings ratio is a simple calculation where you divide the price of the stock by its earnings; you can do this with the earnings for the last twelve months (called “Trailing Twelve Month Price to Earnings” or TTM P/E), or for projected earnings over the next year. Most analysts ground their models in TTM P/E ratios.

Now what is an “acceptable” P/E ratio? The answer is variable, but all P/Es must be compared to some standard. In general, you can use the ratio for the total S&P 500 as an indicator of the market’s perception of what a “normal” P/E ratio would be—in other words, a P/E that is neither too small for a low-growth income producing stock (like MCD, KO, or PG), nor too high for a hyper-growth stock (like GOOG, CMG, or KORS). Currently, the S&P 500 P/E is around 18.6. You can get a glimpse of the S&P 500 P/E ratio on this site.

This small fact has important implications for any stock that has a P/E above 18.6. The market has decided that any stock with a higher P/E ratio than the S&P 500 average is going to have higher than average growth—it is, technically speaking, more of a growth stock than an income-producing stock.

Any stock that has a higher-than-average P/E ratio is going to be hit particularly hard with a revenue or earnings miss, because that miss suggests that the market’s expectations for the company’s growing earnings is more likely to become wrong. Likewise, strong beats, especially on revenue, suggests that the company is growing even faster than most market participants had assumed, so the stock is likely to rise much more aggressively.

This is one reason why institutional investors look at quarterly reports very closely, especially for growth stocks.

This explains the sudden fall in GOOG on its miss. Before earnings, the stock had been trading with a P/E ratio well above 30, and even above 35 when the market was particularly strong before macro weakness hit the tech sector particularly hard (this also ties into the importance of P/E expansion, but that’s another topic for another article). The idea here was that a booming economy and Google’s rapid expansion in several areas, as well as its moat on search, made it a great and rare combination of value and growth.

Then for the first quarter of 2014, the company reported overall revenue growth of 19%. That growth number is rare for a mega-cap company worth over $350 billion, but it does not justify a P/E over 30, because it would take several years of that same level of growth to get to a P/E at or below the S&P average. Likewise, the EPS of $6.27 would bring its TTM P/E ratio to over 28 at pre-earnings levels, and closer to 27 at post-earnings levels. Is 27 more justifiable than 28? If that 19% growth slows even further, we could see it take longer and longer for GOOG to hit a P/E at S&P’s level—meaning the stock will continue to fall and fall in price.

This is why GOOG’s stock crashed in after hours by over 5%, although it recovered somewhat in Thursday morning trading. Right now we are seeing the market debate exactly what that 19% number means for GOOG’s growth prospects in the future. Those price fluctuations reflect an intellectual debate.

With Chipotle, a bit of the opposite is happening. Despite an EPS miss, the company’s revenues rose over 24%, slightly beating estimates. What’s most important here is that the revenue growth was above last quarter’s (20%) and the quarter before that (18%). This means that the company’s total business is growing at a faster and faster pace, meaning that CMG’s total business operations have not yet reached their apex (unlike GOOG, whose 19% revenue growth is a slowdown from previous quarters).

With that better-than-expected acceleration of year-over-year growth, CMG is continuing to prove to investors that it is still growing to fill its sweet spot in the market, which means its current earnings numbers aren’t very important—it will grow into a better P/E ratio as it gets bigger. Thus its pre-earnings TTM P/E ratio of 50 rose to over 55.

Just looking at the surface does not uncover the nuanced relationship between revenue, EPS, P/E ratio, and market position. Yet this is what institutional investors are paid to do by their clients, and this is what most retail investors cannot do for lack of knowledge, time, or resources. Despite cynical media reports to the contrary, hedge funds, mutual funds, and investment banks do not outperform because of insider information, fraud, or questionable tactics—they do it through an intellectually grueling process of analyzing every small bit of a company’s business model and finances.