Growth stocks are those stocks which are expected to grow at a significantly higher rate in comparison to other stocks in the market.
Growth Stocks Basics
Investors who actively look for growth stocks and invest in them focus on increasing their wealth through capital gains when the stock prices of their stocks rise significantly at a very good pace. These investors do not focus to earn through dividend income as the companies that are growing at a very high growth rate, tend to reinvest their profits in their business for expansion purposes.
They usually do not pay dividends to their investors.
Rewards in the stock market always come with risks. The greater the reward one wants, the greater the risk exposure to his/her investment.
Growth stocks generally belong to the young and growing companies, which are also riskier as compared to big, stable and mature companies. Investment in large, stable and mature companies is much safer but the returns are also in the same proportion.
The stock prices of such companies generally do not increase dramatically in a short period of time. On the other hand, this is quite a probable scenario in the case of small, young and growing companies.
How to Find Growth Stocks?
There is no absolute formula that can help us in identifying growth stocks. It will always require some level of interpretation and correct judgement to select growth stocks for one’s portfolio. Let us discuss some key indicators that may help us to identify growth stocks:
1. Earnings Per Share or EPS:
EPS has a direct correlation with stock prices of a company. EPS is calculated by dividing Profit after tax by the total number of outstanding shares.
EPS = Net Profit or Profit After Tax / Total Number of Outstanding Shares
As EPS of a company increases, the stock price also appreciates. The EPS number should be compared with the last years’ EPS numbers.
There should be a track record of strong earnings growth over the previous five to 10 years. This is because if the company has shown good growth consistently in the last 5-10 years, it is likely that it will keep up the performance. Also, a comparison with peers in the same industry can also tell a lot about the financial performance of a company.
2. Competitive Edge:
Companies with high growth rates generally do have certain kind of a competitive edge over their competitors. There can be many possible examples of this like –
Unique Product or Patented Technology – This gives a significant boost to the stock prices
Low-cost products – That may be because of several reasons like access to cheaper raw materials or more efficient processes and types of equipment or a better and more efficient distribution network.
Better Service Quality – This could be in terms of better after-sales service network and customer friendly warranty terms.
3. Growing Reserves of a Company:
Reserves of a company are what we get after subtracting dividend income from Profit After Tax. If there is an increase in reserves numbers over the last few years, it is a very positive and healthy sign for a company. That is because reserves show the ability of a company to be self-reliant.
Companies with good reserves do not have to depend on outside loans in order to meet their capital expenses and execution of expansion plans.
Therefore, they are saving a lot of costs related to debt, thus, increasing the overall profitability and thus, the stock price of a company.
4. Debt to Equity Ratio:
It is one of the most important ratios to analyse the financial health of a company. Debt is not necessarily a bad thing. In fact, in some industries, lack of debt seems to be a negative sign as it shows lack of proper expansion plans. A healthy debt to equity ratio is a good sign.
Although there is no fixed number that can be considered for all companies. The ideal figure for this ratio depends on the kind of industry a company is operating in.
For example, the debt to equity ratio of a sugar manufacturing company could be very different from an IT company. Therefore, this ratio should be compared with other peers in the same industry to make better sense.
5. Profit Margins:
The pre-tax profit margin of a company is calculated by deducting all expenses except taxes from sale and dividing that by sales.
It is very important to look at this number because it is quite possible that the growth in sales of a company is excellent but gains in earnings are poor due to mismanagement of controlling costs and revenues.
This could be an indicator of inefficient management systems and is definitely a red flag on the financial statements of a company. The higher the pre-tax profit margin, the more profitable the company.
The pre-tax profit margin figures of a company should be compared with the figures for the last few years in order to know the direction of the company’s profitability.
6. Return on Equity:
Return on equity (ROE) or Return on Net Worth (RONW) is the amount of net income returned as a percentage of shareholders’ equity. It is a measure of a company’s profitability by taking into account the amount of money its shareholders have invested in.
Return on Equity = Net Income / Shareholder’s Equity
This number should be compared with peers in the same industry as it indicates the effectiveness of converting the cash put into the business into greater gains and growth for the company and its shareholders.
The higher the return on net worth, the more efficient the company’s operations are making use of those funds.
Some of the fastest growing companies in India in the year 2018 are –
Minda Industries Ltd.
Safari Industries (India) Ltd.
Avanti Feeds Ltd. HEG Ltd.
Bajaj Finance Ltd.
Pondy Oxides & Chemicals Ltd.
GM Breweries Ltd.
Aksharchem (India) Ltd.
Since every coin has two sides, the risk factor also comes while investing in growth stocks. The risk involved with investing one’s hard-earned income in growth stocks is that since there is almost no income through dividends, the investors have to depend only on the good increase in the prices of their stocks.
If by any chance, that does not happen due to a certain amount of unpredictability always involved in the stock market, the investor may have to bear losses when they sell their stocks.
Growth Stocks Conclusion
So, now we know that growth investors believe in investing in those stocks which are going to reward them with the great increase in the stock prices in the relatively short period of time.
Growth investing does not focus on companies that are consistently giving dividends to their shareholders but the increase in stock prices is not that impressive. In order to identify growth stocks, one must try to find companies that are unique in some or the other way.
In simpler words, growth investors look for the companies that have some kind of competitive edge in terms of cheaper and better quality products, a patented technology or better after sales service and customer friendly policies.
In identifying growth stocks, one must also befriend the financial statements of companies and have a good grasp over different financial ratios used to compare the company’s growth rate with itself over the last few years and also to compare growth rate with its competitors of the same industry.
One must also look at the management of the company and try to find its effectiveness by reading the management discussion and analysis of the company’s performance over the last few years. That indicates whether the company management is aware of any problems being faced by the company or not.
It should also be seen how efficiently the management is solving the problems and if it is able to keep up the promises to its shareholders. Even after all the analysis, sometimes, things can take a downturn and stock prices may not move in the desired direction.
There is always an element of risk involved in investing in stocks. Growth stocks are risky in the sense that the only way investors can earn by investing in them is through a significant stock price rise. No dividend income is expected out of growth stocks.
Therefore, the risk of losing money remains in adverse situations.
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