7 Ways to Spot the Fundamentals of a Growth Stock

There are two main kinds of investing: value investing and growth investing.

I consider dividend investing to be a subcategory under value investing because dividend investors want to buy relatively cheap stocks with high dividend yields. Growth stocks tend to have the opposite characteristics of value stocks. They are relatively expensive and have low or nonexistent dividend yields.

The good thing about a long-term growth stock – a real winner – is that the stock’s current valuation isn’t very relevant. The stock might have a valuation that’s double the market’s average, which makes it expensive by today’s standards. But, if the company’s earnings grow at a rate of 20% a year, the company’s stock price will rise even more very soon. Valuation isn’t static.

In fact, some studies argue that over the long run a basket of growth stocks will outperform a basket of value stocks!

So how do you spot a relatively new growth stock that still has many years left in the tank?

First, we need to define what a growth stock is:

Definition of a Growth Stock  

A growth stock is a stock of a company that is expected to grow at a pace that is faster than the average for the general stock market.  One of the characteristics of a growth stock is that the stock doesn’t pay a dividend as it chooses to instead reinvest its capital into what is expected to be a more rapid growth of the company.

7 Ways to Spot the Fundamentals of a Growth Stock

1. You Can Find Growth Stocks in Growing Industries

As the saying goes, a rising tide lifts all boats (or most of them at least).

It’s easy to predict which industries will continue to grow because industry cycles last many years if not decades. The internet experienced rapid growth from 1995 – 2010 and only recently has that growth started to slow down. Another example is society’s shift towards healthy dining and away from fast food, which shows no signs of abating. Hence, you don’t really need to predict growth in future industries. You merely need to see what’s happening right now and extrapolate that growth into the future because the current trend will most likely continue for years.

2. Growth stocks tend to buy back their own shares

A lot of growth stocks in the second half of their rapid-growth phase tend to buy back their own shares. So if you see a company that’s doing a lot of share buybacks, it’s a good sign that the company’s earnings and revenues are growing significantly.

3. Look for Growth Stocks That Don’t Have a Lot of Cash

Growth stocks are too busy growing the business, expanding revenue sources, and increasing headcount to leave cash just sitting there. They need all the cash they can get to pursue new business opportunities and expand existing ones!

Having lots of cash means that the company doesn’t know where to reinvest its money anymore. In other words, its growth opportunities are limited. These companies tend to be cash cows like Apple who can’t really grow anymore because:

The industry does not have promising prospects or…

The company has already dominated its industry and is too big.

4. Look at The Growth Stock’s History

Look for a company that has been growing rapidly in the past 3-5 years and make sure that it doesn’t have any strong competitors. Companies experiencing rapid growth without strong competition do not just suddenly see their growth slow down drastically or stop. The rate of growth usually remains steady. Hence, the companies’ current growth rates can be projected a few years into the future.

5. Look for a stock that has just broken out from resistance AND is leading the market

A stock may be stuck in a big range for many months or years. When the stock finally breaks above the top end of this range (resistance) and is rising FASTER than the broad market (e.g. The Dow Jones, S&P 500), that usually means there’s something special about this company. Likewise, a stock that has just made a new all-time high is encouraging. It means that big buyers are accumulating the stock in anticipation of significant earnings growth.

Hence a big breakout is an indication that the company’s fundamentals are much stronger than the broad market’s fundamentals and is probably a growth stock.

Keep in mind that a leading stock doesn’t have to be the biggest company in its industry. A lot of small and medium-sized growth stocks can lead broader stock market advances.

6. A Company Whose Management Owns a Lot of The Shares

Nobody knows more about how well a company will do in the future than management because the executive management team leading the company into the future. If management owns a lot of the shares, it means that the executives believe that the company will grow substantially in the future. If management doesn’t even believe in the future of the company, should you? Probably not.

7. Look for companies that give employees a lot of stock options.

Growth companies typically give their employees and especially the management team a lot of stock options. Stock options ensure that management’s incentives are aligned with growth in at least the stock price (and most likely earnings growth too). You can motivate employees via communication, teamwork, culture-building activities, and all that touchy-feely stuff. But at the end of the day, nothing motivates employees more at stocks options in growth companies. Employees have a huge motivation to work harder and help the company grow faster when they know that they will benefit financially from their efforts.

4 Examples of Excellent Growth Stocks:

Growth stocks have traditionally done better than value stocks in the last couple of decades, but, you need to have the stomach to withstand the potentially large swings in the stock’s value as it goes up and down day-to-day.

Adobe – over the last 10 quarters, Adobe has consistently experienced a greater than 20% growth rate.

Salesforce – this is a personal favorite. Salesforce is a large CRM player has grown at 22% over the last 2 years.

Amazon – yes, Amazon is the A in the word FANG. They have consistently grown at 20% year on year, and have created a large moat around their multiple core competencies.

Microsoft – Microsoft has grown at a rapid pace over the last many years, and are one of the pioneers of the desktop and now cloud market. The have had 10 quarters of over 10% growth.
Good luck with your wealth-creating journey.

You might enjoy this video on how to find growth stocks:

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And this one: How Do You Know When It’s Time to Sell Your Business? It’s Not All About the Money.

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