As the name suggests, growth stocks are companies that grow substantially faster than others. Growth investors are therefore primarily concerned with young companies. The theory is that growth in earnings and/or revenues will directly translate into an increase in the stock price. Typically a growth investor looks for investments in rapidly expanding industries especially those related to new technology. Profits are realized through capital gains and not dividends as nearly all growth companies reinvest their earnings and do not pay a dividend.
No Automatic Formula
Growth investors are concerned with a company’s future growth potential, but there is no absolute formula for evaluating this potential. Every method of picking growth stocks (or any other type of stock) requires some individual interpretation and judgment. Growth investors use certain methods – or sets of guidelines or criteria – as a framework for their analysis, but these methods must be applied with a company’s particular situation in mind. More specifically, the investor must consider the company in relation to its past performance and its industry’s performance. The application of any one guideline or criterion may therefore change from company to company and from industry to industry.
- Strong Historical Earnings Growth?
The first question a growth investor should ask is whether the company, based on annual revenue, has been growing in the past. - Strong Forward Earnings Growth?
The second criterion is a projected five-year growth rate of at least 10-12%, although 15% or more is ideal. These projections are made by analysts, the company or other credible sources. The big problem with forward estimates is that they are estimates. When a growth investor sees an ideal growth projection, he or she, before trusting this projection, must evaluate its credibility. This requires knowledge of the typical growth rates for different sizes of companies. For example, an established large cap will not be able to grow as quickly as a younger small-cap tech company. Also, when evaluating analyst consensus estimates, an investor should learn about the company’s industry – specifically, what its prospects are and what stage of growth it is at.
- Is Management Controlling Costs and Revenues?
The third guideline focuses specifically on pre-tax profit margins. There are many examples of companies with astounding growth in sales but less than outstanding gains in earnings. High annual revenue growth is good, but if EPS has not increased proportionately, it’s likely due to a decrease in profit margin.By comparing a company’s present profit margins to its past margins and its competition’s profit margins, a growth investor is able to gauge fairly accurately whether or not management is controlling costs and revenues and maintaining margins. A good rule of thumb is that if company exceeds its previous five-year average of pre-tax profit margins as well as those of its industry, the company may be a good growth candidate. - Can Management Operate the Business Efficiently?
Efficiency can be quantified by using return on equity (ROE). Efficient use of assets should be reflected in a stable or increasing ROE. Again, analysis of this metric should be relative: a company’s present ROE is best compared to the five-year average ROE of the company and the industry.5. Can the Stock Price Double in Five Years?
If a stock cannot realistically double in five years, it’s probably not a growth stock. That’s the general consensus. This may seem like an overly high, unrealistic standard, but remember that with a growth rate of 10%, a stock’s price would double in seven years. So the rate growth investors are seeking is 15% per annum, which yields a doubling in price in five years.