How to find the best growth stocks?

In this post we go over the typical quantitative characteristics for growth stocks. If you want to know more about what the term 'growth stock' actually means, we recommend that you first read this article.

QUANTITATIVE CRITERIA

Revenue Growth

A first important measure for identifying growth companies is by looking at revenue growth. It is important that there is steady revenue growth over several quarters. Faster is better but don't be blinded by the sometimes unbelievable growth rates that a company can present at the beginning. Such a pace that sometimes exceeds 100% may be impressive, but it is impossible to sustain over the longer term. So focus on continuous growth rather than the growth rate and eliminate companies that show very irregular growth or even slower growth. An annual turnover growth of at least 20 to 30% for both the past and coming years is a good general measure for typical growth companies.

Earnings per Share Growth

Ultimately, the goal is for companies to make a profit, but with growth stocks, this criterion requires some nuance. Investors in growth stocks are mainly looking for companies that are still at the beginning of their success and thus in many cases on their way to profitability. Profit is therefore not yet a necessary condition. Companies whose net losses are structurally decreasing while revenues continue to grow are certainly worthy candidates for the growth investor. This brings us to two typical characteristics that are necessary with this type of investor; patience and trust. Confidence in the way the company acts and progresses and patience to wait until that growth also shows in the stock price performance.

Market Capitilization (Market Cap)

The market capitalization of the company is another value measure that can be included in the selection of growth stocks. Now, it would be unwise to simply exclude companies on the basis of their allegedly too high market capitalization, but it remains a logical reasoning that companies with a rather limited market capitalization have more growth potential than the large established values. Trees don't grow to the sky... In many cases you will also find that sufficiently large companies will pay out dividends rather than invest in further growth.

Debt/Equity Ratio

This ratio is used to determine the extent to which the company uses equity or incurs debt to finance its activities. It is not illogical that start-up growth companies finance themselves partly through debt, but it is important that this does not happen excessively as it involves interest charges. Also keep in mind that this ratio is very much dependent on the sector in which the company operates. Some sectors are more capital-intensive than others. The general consensus is that a ratio between 1 and 1.5 is considered normal, with 2 being just about the maximum acceptable. For some very specific capital-intensive industries, that figure is even higher.

Price Earnings and Price Sales (P/E and P/S)

Once you have found companies with more than decent sales and earnings growth and an acceptable debt ratio, it is important not to overpay for such a growth stock. Be aware that you are not the only one looking for such "growth pearls" and as with any other product there is a relationship between demand and price. If demand is high, the price will be correspondingly high. It is quite normal with growth stocks that you pay a premium, as there is a bet on the future of the company. If you are only prepared to buy shares with a price significantly lower than the intrinsic value, then perhaps buying growth shares is not the best option for you... However, this does not mean that you have to pay the highest price. If you keep buying overvalued growth shares it will undoubtedly be detrimental to your returns. As soon as the buyers' enthusiasm for this particular stock subsides for whatever reason, this will generally have a fairly strong negative effect on the price.

Two ratios that can help you avoid overpriced stocks are the price/earnings and price/sales ratio of a stock. An acceptable P/E and P/S combined with expected attractive sales and earnings growth are good catalysts to avoid overpriced stocks. Again, you should only interpret and compare the ratios within the same industry or sector.