At this level of the stock market it is hard to find reasonably priced stocks nowadays that still offer high growth potential in the long term. A lot of investors buy value stocks and expect 10-times returns. But if you want above average gains, most value stocks simply do not offer these kind of returns. You have to look at growth stocks. Growth stocks increase their revenue at a faster rate than the average business in their industry or the general market. They are usually at the forefront of macro trends.
To find such growth stocks, here are 7 signs to identify a high potential growth stock:
1. Small- or Mid-Cap stocks
Large-cap stocks are great for dividend income, while smaller companies that are still expanding have typically a higher growth potential. Small- and mid-cap stocks also fly under the radar of many fund managers because of their size and low liquidity. Retail investors have the opportunity to invest in these smaller companies early until they grow large enough for fund managers to start paying attention to them.
2. Less than 50% dividend pay out ratio
A company in an early stage of growth should be retaining most of its profits for business expansion. That’s why a growth company should have a dividend pay out ratio of 50% or less.
3. 3-5 years of growth
A growth company should have a track record of tangible growth over the last 3-5 years. We look for consistently rising revenues, profits and cash flow. These umbers tell you the real story. Invest, once you see hard evidence of stable and sustainable growth.
4. Strong growth drivers
Having a past track record of growth is one indicator but it doesn’t guarantee a company’s future growth potential. Some companies might grow quickly over the first few years then stagnate thereafter. Study the company’s industry, business model and management team very carefully.
5. Strong balance sheet
A company must have a strong balance sheet. It should have a good cash position and low, manageable debt levels. Little cash and crippling debt can stop the growth process quickly.
6. High return on equity
Return on equity (ROE) is one the of the most important criteria for evaluating companies. ROE measures how much profit is generated with the money shareholders have invested in a company. A high ROE means management is able to allocate capital efficiently to generate returns for shareholders. Look for low-debt companies that generate an ROE of 15% or higher over the past 3-5 years.
7. Strong cash flow
For growth stocks, free cash flow is usually low or negative because growth companies reinvest much of their cash into capital expenditure to grow their business. Instead of free cash flow, look for consistently rising operating cash flow.
While researching your next growth stock investment, pay close attention to these 7 signs.
Sven Franssen