Stock-Picking Strategies: Growth Investing

One way to define growth investing is to compare it to value investing. While value investors look for stocks that are trading for less than their intrinsic value today, growth investors focus on the future potential of a company, with much less emphasis on the present price. Unlike value investors, growth investors buy stock in companies that are trading higher than their intrinsic value – with the assumption that the intrinsic value will grow and ultimately exceed current valuations. Ultimately, growth investors try to increase their wealth through long- or short-term capital appreciation.

Profits from Capital Gains – Not Dividends

Growth investors typically invest in companies whose earnings are expected to grow at an above-average rate compared to the its industry or the overall market. As a result, growth investors tend to focus on young companies with excellent growth potential. The idea is that growth in earnings and/or revenues will translate into higher stock prices in the future. Growth investors typically look for investments in rapidly expanding industries where new technologies and services are being developed, and look for profits through capital gains and not dividends – most growth companies reinvest their earnings rather than pay a dividend.

What to Look For

There is no absolute formula for evaluating this potential; it requires a degree of individual interpretation and judgment. 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.

You can find growth stocks trading on any exchange and in any sector – but you’ll usually find them in the fastest-growing industries. Some general guidelines you might include as part of your growth investing strategy would be to look for companies with:

• Strong historical earnings growth. Companies should show a track record of strong earnings growth over the previous five to 10 years. The minimum EPS growth depends on the size of the company: for example, you might look for growth of at least 5% for companies that are larger than $4 billion, 7% for companies in the $400 million to $4 billion range and 12% for smaller companies under $400 million. The basic idea is that if the company has displayed good growth in the recent past, it’s likely to continue doing so moving forward.

• Strong forward earnings growth. An earnings announcement is an official public statement of a company’s profitability for a specific period – typically a quarter or a year. These announcements are made on specific dates during earnings season and are preceded by earnings estimates issued by equity analysts. It’s these estimates that growth investors pay close attention to as they try to determine which companies are likely to grow at above-average rates compared to the industry. 

• Strong profit margins. A company’s pretax profit margin is calculated by deducting all expenses from sales (except taxes) and dividing by sales. It’s an important metric to consider because a company can have fantastic growth in sales with poor gains in earnings – which could indicate management is not controlling costs and revenues. In general, if a company exceeds its previous five-year average of pretax profit margins – as well as those of its industry – the company may be a good growth candidate.  

• Strong return on equity. A company’s return on equity (ROE) measures its profitability by revealing how much profit a company generates with the money shareholders have invested. It’s calculated by dividing net income by shareholder equity. A good rule of thumb is to compare a company’s present ROE to the five-year average ROE of the company and the industry. Stable or increasing ROE indicates that management is doing a good job generating returns from shareholders’ investments and operating the business efficiently.

• Strong stock performance. In general, if a stock cannot realistically double in five years, it’s probably not a growth stock. Keep in mind, a stock’s price would double in seven years with a growth rate of just 10%. To double in five years, the growth rate must be 15% – something that’s certainly feasible for young companies in rapidly expanding industries.