Growth investors look at a company’s or a market’s potential for growth. There is no absolute formula for evaluating this potential; it requires a degree of individual interpretation, based on objective and subjective factors, plus personal judgment. Growth investors may use certain methods or criteria as a framework for their analysis, but these methods must be applied with a company’s particular situation in mind: Specifically, its current position vis-a-vis its past industry performance and historical financial performance.
In general, though, growth investors look at five key factors when selecting companies that may provide capital appreciation. These include:
Strong Historical Earnings Growth
Companies should show a track record of strong earnings growth over the previous five to 10 years. The minimum earnings per share (EPS) growth depends on the size of the company: for example, you might look for growth of at least 5% for companies that are larger than $4 billion, 7% for companies in the $400 million to $4 billion range, and 12% for smaller companies under $400 million. The basic idea is that if the company has displayed good growth in the recent past, it’s likely to continue doing so moving forward.
Strong Forward Earnings Growth
An earnings announcement is an official public statement of a company’s profitability for a specific period—typically a quarter or a year. These announcements are made on specific dates during earnings season and are preceded by earnings estimates issued by equity analysts. It’s these estimates that growth investors pay close attention to as they try to determine which companies are likely to grow at above-average rates compared to the industry.
Strong Profit Margins
A company’s pretax profit margin is calculated by deducting all expenses from sales (except taxes) and dividing by sales. It’s an important metric to consider because a company can have fantastic growth in sales with poor gains in earnings—which could indicate management is not controlling costs and revenues. In general, if a company exceeds its previous five-year average of pretax profit margins—as well as those of its industry—the company may be a good growth candidate.
Strong Return on Equity (ROE)
A company’s return on equity (ROE) measures its profitability by revealing how much profit a company generates with the money shareholders have invested. It’s calculated by dividing net income by shareholder equity. A good rule of thumb is to compare a company’s present ROE to the five-year average ROE of the company and the industry. Stable or increasing ROE indicates that management is doing a good job generating returns from shareholders’ investments and operating the business efficiently.
Strong Stock Performance
In general, if a stock cannot realistically double in five years, it’s probably not a growth stock. Keep in mind, a stock’s price would double in seven years with a growth rate of just 10%. To double in five years, the growth rate must be 15%—something that’s certainly feasible for young companies in rapidly expanding industries.