How to Identify Growth Stocks?

If you are looking to invest your money in stock markets, there are several things that you should know before you take the leap to purchase. Of the many stock market investment strategies, we are going to discuss in this blog what growth stocks are and how to identify them.

What is a growth stock -

A Growth Stock is a share in the company which is expected to increase its earnings at a rate above the average market numbers.

A growth stock company usually pays no dividend and chooses to reinvest the retained earnings (NOPAT- Net Operating Profit After Tax) as capital for potentially profitable projects. It can be one of those technically advanced companies that hold patents.

Investors who own growth stocks are interested because there is a potential for huge capital gains. At the same time it is a risky business as great upside potential goes hand in hand with great downside potential. Some examples of Indian growth stocks are Suntec Realty, Edelweiss Financial, Ajanta Pharma, etc. Let us delve deeper to know seven ways to identify a growth stock.

How to Pick the Best Growth Stocks

1.  Accelerating Sales:

Sometimes, a company may not show very high profits, but their sales would top the charts. A classic example of this is Eicher Motors. Look out for such companies as they show great promise to perform once they take off.

2. Upward Trend in Earnings Growth:

The Earnings Per Share or EPS of a company indicates how profitable a company is. The ratio is the retained earnings to the number of shares a company holds. One would like to invest in a company with an upward trend in its EPS as they are perfectly capable of paying its shareholders a high return for their investment.

3. Return on Equity:

 Return on equity comes topmost on Warren Buffet’s list of criteria for evaluating companies.

Return on Equity or ROE measures how well the money invested by the shareholders in the company by dividing the net income by shareholders equity. If a company is aiming for growth, it efficiently allocates its capital through equity. A growth stock company retaining its capital for expansion should be able to show that they are able to generate high returns for their shareholders through equity, else there’s no point for such retention.

4. Balance Sheet:

 A strong balance sheet is one with low debt over a good cash position. Liquidity is an important factor for growth. Many companies expand quickly only to realize that they do not possess liquid cash enough to settle the debt and borrowed capital used for such growth.

A company that has a high debt and borrowing may focus mainly on repayment rather than growth. They are also under the constant fear of winding up due to insolvency.

5.  Strong Cash Flow:

 Strong inflow of cash indicates high sales turnover or the sale of a company’s own subsidiaries, overseas branches or even heavy machinery. A company with a lot of free cash flow is target for high dividend seekers, since they expect payment out of such free cash. On the other hand, growth stock companies are low on free cash because it is converted into capital expenditure or Cap Ex for business growth.

A good way to inspect a growth stock is to check its operating cash flow rather than the free cash flow. Consistent and increasing operating cash flow is a good indicator that a company is getting new money from capital expenditure.

6. Dividend Payout Ratio and Retained Earnings:

 A growth stock company preferably has a dividend payout ratio of 50% or lower. The dividend payout ratio is the return paid to shareholders based on the company’s net income by means of dividend. The amount that is held back for growth and reinvestment by the company is called retained earnings.

A growing company usually keeps all the profits to expand and diversify its business. A matured one that has established itself in the sector prefers to share its profits with its members.

7.  Growth Track: 

Every company leaves a trail of its progress and success behind. A growth stock company should have a trail of tangible growth in the past 3-5 years. Evaluate the company’s records for concrete evidence of cash flow, profits, rising revenues and sales. You may come across several companies selling the investors only dreams that soon turn to dust once trapped in the scam. It is important that investors do not fall for charismatic words of growth, expansion and high returns before they check for stable growth over a period of time.

Bonus Tip:  Look for small and mid- sized companies, as they have prospects for higher growth. These companies are not very high on liquidity and hence give retail investors the opportunity to own the shares of the company before it grows. A Matured company’s focal point is usually giving back to its investors and hence is more often than not a dividend centric investment.

Bottom-line:

Finding growth stocks can be a fun part of your research. India is the fastest growing economy in the world, which results in highly profitable companies. Growth stocks can come in all forms, be it mature companies or wee start-ups that are just on the verge of a break through. Many a times it is difficult to recognize one apart from a financial angle.

Several companies are well hidden under the radar in extremely technical or strategic industries; they may seem modest, but the future trends may be in their favour. If you are trying to stay safe in the stock market, monitor the current stock market trends since risk is ancillary to this adventure. Huge stakes means so much to win, but also too much to lose.