A growth stock is typically a company that exhibits growth in sales and profitability at a higher rate than similar companies and so operates in an industry that is demonstrating secular growth trends that are outpacing the general economy and the overall market. A diversified portfolio should have a balance of growth stocks as well as more defensive, income generating (via dividends) stocks.
A sensible way to identify high-growth stocks is to look for structural trends in the economy that are likely to play out over multiple years, if not decades. Companies who participate in these trends and particularly those who are industry leaders and help to shape this structural change, are likely to demonstrate high rates of growth in their revenues and profits.
Some examples of these structural trends include:
- Technology is likely to be the most significant trend of our lifetimes. The advent and growth of the internet and software has impacted almost all facets of our lives – mobile phone usage, internet search, cloud servers and data storage, e-commerce, video streaming – all of which are structural trends themselves.
- Aging population, particularly in the developed economies is dramatically changing the demographic makeup of economies. The aging population is placing a greater emphasis on certain consumption patterns, most notably in healthcare (pharmaceuticals, biotechnology and medical devices) and aged-care facilities.
- Sustainability is an increasingly important trend as consumers acknowledge the growing need to find more sustainable ways to live. This could range from utilising more renewable forms of energy (solar, wind, batteries) at the expense of fossil fuels, increasing recycling practices to improving the efficiency of our building and manufacturing practices.
Once a trend is identified, it is important to identify those companies, which are best positioned to leverage and benefit from these trends.
This requires an analysis of a company’s financial statements (income statement, balance sheet, cash flow and other operational data) as well as economic and market information such as the company’s market positioning and market share, industry dynamics and the regulatory environment in which it operates.
An investor should look for the following characteristics to identify the best, high-growth companies within a trend:
- A business model or product or service that is difficult to replicate and has high barriers to entry for its competitors;
- Industry leading position with strong brand name(s);
- Consistently growing earnings that are growing above industry peers and the general market; and
- A balance sheet that is not over-geared
The final step in selecting high-growth stocks as investments is to ensure that they are valued appropriately. High-growth stocks are typically more expensive than lower-growth stocks (by utilising valuation metrics such as price-to-earnings ratio, price-to-sales ratio and cashflow ratio) as investors are willing to pay more for these high-growth stocks. As the name implies, these valuation metrics are calculated as follows:
- Price-to-earnings ratio compares a company’s share price to its earnings.
- Price-to-sales ratio compares a company’s share price to its revenues or sales.
- Cashflow ratio measures how well a company’s current liabilities are covered by the cashflows it generates from operations.
However, investors need to also be wary about not overpaying for high-growth stocks either. One method of doing this is to compare a company’s price-to-earnings ratio to its growth rate for that particular year – this is considered its price-to-earnings to growth ratio (“PEG”). The lower the PEG, the better valuation for an investment to be considered, all other things being equal.
As an example, let us consider two companies in the technology industry, Microsoft and Apple. Both are industry leaders, have attractive fundamentals including being leveraged to a number of structural trends and both have the hallmarks of being great high-growth stocks despite their significant size, but which has the better PEG valuation?
- Microsoft 1 year forward price-to-earnings ratio is 28.0x with earnings growth of 13.5%, giving us a PEG of 2.05x
- Apple 1 year forward price-to-earnings ratio is 29.5x with earnings growth of 19.0%, giving us a PEG of 1.55x
The 1 year forward price-to-earnings ratio is calculated by taking the forecast earnings over the next year, divided by the current stock price.
Although Apple is trading on a slightly more expensive price-to-earnings ratio of 29.5x, analysts are expecting it to grow earnings by 19.0% (compared to 13.5% for Microsoft). This means Apple has a lower PEG ratio and therefore, it can be argued that it is a relatively better investment than Microsoft, all other things being equal.
Sourcing the information
The advent of the internet has allowed much of the above company and industry information to be freely available on various financial and aggregated websites. Financial research reports written by banks and other financial intermediaries can be good sources of information although these are not always made available widely to the public.
Company information is best sourced from the company directly including its financial statements, investor presentations and any prospectuses (when a company issues new capital). Many companies will also provide some future guidance about future expectations on revenues and earnings, which will help an investor assess the company’s growth prospects. However, an investor should assess this information objectively taking into account other sources of information from the industry, competitors and research analysts to form an independent view.
Getting this independent view correct (even if it can sometimes be at odds with what the company is guiding) is one of the keys to successfully identifying high-growth stocks as sound investments.
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About Elevate Super
Elevate Super is a retail super fund, powered by successful fintech AtlasTrend. AtlasTrend was created in 2015 to build a new investment service to help our customers learn and invest with purpose in long term world trends. At Elevate Super, we believe you shouldn’t have to give up competitive financial returns to do good.
We assess and measure investments based on their long-term growth fundamentals plus positive contribution to the UN Sustainable Development Goals (SDGs) – a global blueprint for balancing our economic, social and environmental needs.