How to find a Growth Stock- what makes a stock a Growth Stock

A growth stock, by definition, is a stock that has a growth rate much superior to average growth rate of the stock market. Ideally, the earning growth demonstrated by a growth stock should be growing at far higher rate than an average stock in the stock market. When people talk about growth stocks, they invariably talk about value stocks in the same breath. The key difference is that much of the valuation of a growth stock depends on its future performance and the valuation of a value stock depends primarily on its past performance.

You should be very clear about two things. First, what growth a growth stock is, and second, whether what people are claiming as a growth stock is really a growth stock.

Let’s try to first understand what a real growth stock is. A real growth stock is a stock that has been showing an above average growth rate in its earning and sales over the last 4-5 years consistently without compromising on its business fundamentals and financial future. If a company has been funding its growth through unsafe loans, which will cripple its earning capacity in near future, it can’t be called a growth stock. You should also pay attention to growth in per share earning on diluted basis ( earning per share after taking into account preferential shares, warrants, stock options, etc). The earnings overall might have grown, but have earnings per share grown? If not, then, the stock can’t be called a growth stock. After all, you will pay premium for the expected growth of earning per share in future. If the company management has not grown per share earning in the past, you can’t just trust it to do so in future.

A growth stock should never be considered for its growth alone. Consistent growth in earnings could be a reason why you want to evaluate it for investment purpose. However, make sure that you analyze the stock thoroughly the way you will analyze any other stock. You can be a little liberal in assessing a growth stock in a few parameters like Price to Earning Ratio or Dividend Payment. However, there should not be any let up in the assessment of the financial stability and management quality.

In a growth stock, the earning growth should more than make up for the liberal PE ratio or lower dividend payment. While evaluating a growth stock, be especially careful to take into account a few other factors like:

· Net Current Asset Value in order to determine the financial viability of the firm in question
· Current Asset Value in order to determine short-term financial viability of the firm
· Debt to equity ratio
· Quality of the Current Assets.
· Performance and the credibility of the management
· Change of management in recent years and its impact

How should you find whether a so-called growth stock is really a growth stock or not? If you browse through recommendations of many investment analysts in the current environment, you will find that many of them claim that they are following growth-investing philosophy while recommending stocks. Most of them have favorite stocks that have shown promise in recent years. These stocks would have grown their sales and earnings at exponential rates in the last 2-3 years. Based on this sudden spurt in their performance in the recent past, analysts start recommending these stocks as growth stocks. As is expected, many lay investors blindly jump in to investing in these so called ‘growth stocks’ without even understanding the businesses behind these stocks. These stocks are not growth stocks; instead they are fashion stocks. Every once in a while stock markets come up with their favorite fashion stocks which are bought and sold blindly without any consideration to their underlying business value. A little peek into the history should keep us sane as most often these misinformed investment result in disastrous returns and heartbreaks. Before investing in any stock, you need to analyze it thoroughly to be confident of its value as explained in this post earlier.

How to Select a Stock- Part IV- Financial Stability

In this post we will try to learn how we can ensure that the money we are going to invest in a company doesn’t go down the drain. Essentially, we will try to evaluate the intrinsic financial soundness of the company and understand the financial ratios or filters that we need to apply to remove risky companies from our consideration set.

Debt to Equity Ratio: Ideally, debt should not account for more than 50% of the total capital of the company. If the debt is more than 50% of the total capital, the company’s survival might be at risk.

Ratio of earning to fixed charges: The company should be at least able to cover its interest charges many times over. If the earnings are not covering its interest costs, it will have to borrow more to pay its interest- a situation that’s not sustainable for long term. Such companies might be very risky even if their long-term growth prospects are promising.

Current Ratio: Current ratio measures a company’s ability to pay off its short-term liabilities. It’s the ratio between the current assets (cash and other assets like inventory or receivables that can be converted into cash within a year) and the current liabilities (short term loans, accounts payable and other obligations that need to be paid within a year) of the company. Ideally, the current ratio should be at least 1.5 for a company. If the ratio approaches 1, you should be seriously concerned and look for more details on how the company is going to meet its obligations.

Long Term debt: The long term debt of a company should not exceed its working capital (Current Assets- Current Liabilities). This is a measure of the company’s ability to meet its long-term obligations with ease.

Size of the company: The bigger the size of the company, the safer it will be for you to invest in it considering all other things equal. The bigger companies have grown big because they have done well in the past. By definition, they should have more share of the business than their competitors and should be generating more cash.

While I have talked about various ratios in this post, I would like to emphasize that these ratios are not cast in stone for all companies and all industries. The recommended values ideally apply to majority of the industrial companies and can vary across industries. The recommended ratio values will help you stay in the safe territory while investing in stocks. Even in the safe territory, you will find enough number of companies you will be able to choose from for investment purposes. Hence, it will serve you well if you stay in the safer side of these ratios. Of course, the final call is yours based on your judgment and experience.