This article will shed light on the defining features of growth stocks, and how to encapsulate them in your growth stock screener criteria. I will then show you how to apply this criteria into one of my favourite stock screeners, ChartMill, so you can find growth stocks in no time.
What Are Growth Stocks?
Growth stocks are companies with above average sales growth and/or earnings growth. They typically don’t pay dividends as they reinvest their cash for expansion instead. As such, growth investors expect to make money from capital appreciation as opposed to dividend income.
Due to the prospect of strong earnings growth, growth stocks tend to trade at high valuation multiples. This makes them risky investments, as any disappointment relative to expectations can lead to a sharp de-rating and share price correction.
Growth Stock Screener Criteria
Every growth stock screener criteria involves a combination of the following metrics. You can obtain all of these from a financial analytics platform like Koyfin.
Earnings Growth
Earnings growth is the average annual growth rate in earnings per share over a certain period of time. Personally, I like this to be a period of 3-5 years. This is enough time to establish a convincing track record in my eyes.
Anything shorter, such as 1 year, is too noisy in my opinion. Any company can have a good year, particularly if earnings were depressed in the year before. To classify as a growth stock, however, there needs to be a certain degree of persistence.
The most common way to calculate earnings growth is with a compounded annual growth rate (CAGR). This has the following formula:
EPS (end) is the most recent earnings per share, and EPS (start) is the beginning value you want to compare it against. n is the number of years between them.
For example, if we wanted to calculate the 5-year CAGR for Apple, we need the most recent trailing twelve months (TTM) earnings per share ($6.16), and the same TTM EPS from 5 years ago ($2.13). Then we plug these into the equation above, using n=5.
Therefore, Apple has compounded earnings at an average annual rate of 23.7% over the last 5 years.
What is a Good Earnings Growth Rate?
There is no definitive answer for this, as there are so many different variables affecting what “good” is.
For example, we can’t expect companies to achieve the same growth rates in a recession and an expansion. Also, we can’t expect all industries to grow at the same rate, and large companies to grow faster than small companies.
Putting all these nuances to one side, however, there are luckily some useful benchmarks to give us a rough guide.
For example, in this Peter Lynch stock screener article, I explain how Lynch likes to see growth rates between 20-30%.
Another way to gauge what a “good” rate of growth is, is to see what the fastest growing companies are currently growing at. We can then use that as a benchmark to compare other stocks against.
For example, growing earnings by more than 31% over the last 5 years will have put you in the top 10% of fastest growing stocks in the S&P 500. Growing them by more than 24% put you in the top 20%, and more than 18% in the top 30%.
Based on this, I think anything above 15% classifies as a good rate of growth.
Sales Growth
Sales growth is the average annual growth rate in sales over a certain period of time. As with earnings, the standard convention is to use a 3-5 year CAGR.
Sales growth is as important, if not more important, than earnings growth when screening for growth stocks.
As I explain later, many growth companies don’t have any earnings yet. So, if you want your screen to capture these stocks, your screening criteria should only focus on sales.
If you exclude earnings from your screen though, expect the screener to generate a slightly more speculative list of stocks than usual.
Another thing to consider, is that sales give you an unbiased picture of company performance. Unlike earnings, sales can’t be manipulated with accounting tricks.
Additionally, earnings are a function of a number of things, such as cost-cutting measures. In contrast, sales are driven by two things: prices and volume. As such, sales give you a top-level view of pricing power and demand for a company’s products.
When it comes to screening, it isn’t a choice between one or the other. Most of the time, investors will screen using both earnings and sales. This is because they like to see good top and bottom line performance.
What is a Good Sales Growth Rate?
Again, there is no ‘right’ answer for this. As with earnings, you need to apply a certain level of discretion depending on the economic climate, geography, or sector a company belongs to.
In general though, expect sales growth to be lower than EPS growth. The reason being that there are more ways to increase earnings than there are sales.
Cost-cutting is one example already touched on. Another is operating leverage. Operating leverage occurs when a company has a high proportion of fixed costs in its cost base. As sales rise, there is more money to spread those fixed costs over – which boosts earnings disproportionately more than sales.
The only time sales growth will exceed earnings growth, is when a company cuts prices to steal market share. Whilst this can bolster the top-line through an increase in demand, it can also weigh on margins, and hence profitability.
As I explain later, this is an unsustainable strategy. Therefore, be wary of companies growing sales faster than earnings for a prolonged period of time.
On the flip side, you also don’t want to see earnings growing a lot faster than sales. If this is the case, it means that cost-cutting measures are driving earnings. This isn’t sustainable either.
In this Martin Zweig stock screener article, I explain how Zweig likes to see both earnings and sales growing at relatively similar rates.
As a general rule of thumb, I like to see sales growing at least half as much as earnings. For example, if earnings are growing by 20%, sales should grow at least 10%. This acknowledges the fact that sales generally grow slower than earnings, but also ensures it doesn’t lag too far behind.
With all this said, anything greater than 7-8% is a pretty respectable rate over a 3-5 year period.
Growth Forecasts
The previous two measures concerned historical growth. This is great for understanding how a company actually performed in recent years.
Of more importance though, is where the company is going in the future. The stock market is forward-looking after all.
Therefore, another important growth measure for your stock screener criteria is growth forecasts. These are based off analyst earnings estimates for the next few years.
Obviously, the risk with forecasts is that they turn out to be wrong. This is particularly the case the further you look into the future. Therefore, a forecast period of 2-3 years is ideal in my opinion. Anything shorter is meaningless, and anything longer risks forecasting errors.
When screening with this metric, you’re checking that analysts don’t expect growth to suddenly deteriorate. As mentioned earlier, this is one of the greatest sources of risks for highly-valued growth stocks.
Earnings Revisions
Earnings revisions measure the rate of change in earnings/sales forecasts. As such, it is a more dynamic measure that tracks momentum in growth, as opposed to levels. This strategy performs extremely well in backtests. To see just how profitable it is, read this article about my earnings revisions stock screener strategy.
Return on Equity
Return on equity helps investors decipher the quality of growth.
It divides net income by shareholders’ equity, and can be broken down into the following components with DuPont analysis:
If return on equity falls at the same time that growth rises, this can indicate a couple of problems:
- Margin decline: Growth comes at the expense of profitability – likely as a result of price cutting/discount selling.
- Low asset turnover: Asset expansion is responsible for growth, but leads to a less than proportional increase in sales. This indicates inefficient asset allocation.
On point 2, if asset growth is financed with debt, this can offset a lower ROE via an increase in financial leverage.
This is far from ideal though, as it increases the risk of the business. In turn, the cost of equity will increase, which limits the amount of shareholder value created.
Ideally, we want to see a stable or growing ROE alongside strong growth.
Read this article about quality stock screener metrics for a deeper dive into the return on equity and other fundamental ratios.
Debt-to-Equity
As we’ve just seen, debt is one way that a company can boost its return on equity and growth.
In theory, a company can grow in perpetuity if you give it an infinite supply of capital. However, using leverage to grow just for the sake of it is not sustainable long-term.
Therefore, including a debt-to-equity threshold in your screen can eliminate companies using excessive debt to finance growth.
What is a Good Debt-to-Equity Ratio?
A good debt-to-equity ratio is generally anything less than 1.5.
PEG Ratio
The PEG ratio is a valuation metric that divides the P/E ratio by earnings growth.
This helps investors contextualize whether a company looks expensive or not relative to its growth profile.
A company with a PEG ratio less than 1 is usually considered cheap.
Read this article about value stock screener criteria to get a full overview of the PEG ratio and other valuation ratios.
Growth Stock Screen
Below are some criteria for a very basic growth stock screen based on the metrics outlined above:
- 5-year EPS CAGR > 15%
- 5-year Sales CAGR > 10%
- 3-year EPS gr. forecast > 10%
- ROE > 10%
- D/E < 1.5
- PEG Ratio < 1.5
ChartMill is one of the very few stock screeners that includes all of these metrics, which you can read more about in my ChartMill review.
By adjusting the relevant sliders to the desired values, our initial stock universe of over 22,000 stocks narrowed down to just 65.
This now gives you a much better starting point to conduct further research, in the knowledge that you will only be looking at high-quality, fairly valued growth stocks.
Value vs. Growth Stocks
The most obvious difference between value and growth stocks is their valuation. By definition, value stocks are those which trade at cheap valuation multiples, such a price-to-earnings, price-to-sales, or price-to-book ratios.
On the contrary, growth stocks trade at high valuation multiples. This is because most of their value derives from the future – when earnings are expected to be higher.
Investor psychology also tends to be different for growth and value stocks. Growth stocks generate investor hype, whereas value stocks are overlooked by the market.
The reason being that growth stocks are usually geared into the latest hot trend, whether that be artificial intelligence, electric vehicles, or gene therapy. Growth investors seek to ride these trends, which makes their approach more aligned with trend-following, or momentum investing.
On the other hand, value stocks are usually in slow-growing industries, or industries going through disruption. This means they are off the radar scope of most investors.
As such, value investors are more patient. They adopt a more contrarian approach and take advantage of the market’s ‘ignorance’ to accumulate cheap companies. When the market eventually catches on, early value investors stand to profit from the subsequent revaluation.
Quality vs. Growth Stocks
There is a lot of overlap between quality and growth stocks, which makes their difference slightly more blurred.
Like growth stocks, quality stocks possess strong growth features. The key difference for a quality company, however, is that this growth is sustainable over the long term.
Many growth stocks experience a short burst of growth before petering out. This is usually due to fierce competition and loss of market share. Quality companies, on the other hand, are able to maintain their competitive advantage through consistent innovation. This means that they stand the test of time, rather than being a ‘flash in the pan’.
Quality Stocks Are Very Profitable
Moreover, quality companies are usually very profitable. This contrasts with a lot of growth stocks which don’t make any money yet. Many growth stocks are young, or even startups. At this stage in their life cycle, they reinvest most of their sales back into the business to achieve a certain degree of scale and market share. Profitability is a secondary thought.
They are given the benefit of the doubt by investors in these early days, because the sales growth is impressive and they believe that profitability will come in the future. For this reason, many growth companies are priced off of sales as opposed to earnings.
Quality stocks have already been through this stage and made it to the other side. Having established a strong foothold in their industry, they now have the scale and pricing power to focus on profits. A quality stock screen will therefore include more profitability ratios. This article shows you how to incorporate profit margins into a stock screener strategy.
Of course, they won’t be able to achieve the same growth rates as when they were younger, but they now have an ideal balance of profitability and steady growth. This is sometimes called ‘quality growth’.
In this light, quality stocks are at the next stage in the life cycle to growth stocks. Quality stocks are well-established companies with a proven track record. Growth stocks, on the other hand, are generally smaller and more speculative.
Attributes of High Growth Stocks
Below are some of the most common qualitative traits that growth stocks possess. By marrying this together with the quantitative criteria from your growth screen, you will find high growth companies in no time.
Fast Growing Industry
Many growth stocks owe their growth to the industry they operate in. Fast-growing industries are driven by high demand, which provides a tailwind to the revenues of individual companies. “A tide that lifts all boats” is a common saying attributed to this phenomenon.
The semiconductor industry is a good example of this in recent years. With the proliferation of new technologies like cloud computing, artificial intelligence (AI), and internet of things (IoT), as well as the explosion in personal data from our devices, demand for chips has gone through the roof.
As a result, chipmakers and equipment manufacturers have seen their profits soar over the last few years.
Large Addressable Market
Another common trait of growth stocks is that they provide a product or service with a large addressable market. This is the potential pool of customers that they can sell to. The larger this is, the larger the source of demand they can tap into.
A large addressable market lengthens the runway to attain growth. One, because it takes longer to saturate demand. And two, because it’s harder for competition to crowd out that demand.
Increasing Market Share
A company stealing market share can grow regardless of underlying industry growth. Market share growth can indicate a company with strong competitive advantages over its peers. This could be a superior product, brand loyalty, or economies of scale. Whatever it is, market share growth is usually an encouraging sign for a company’s prospects.
I should probably caveat that with one point. If market share is only increasing due to price cutting, then this is an unsustainable strategy. Once consumers get used to discounts it is very hard to reverse that psychology. This can impact your brand image and curtail future profitability. Coca-Cola still struggles today with profitability in North America because it taught consumers to buy in bulk on sale.
Network Effects
Network effects arise when the value of a product or service increases exponentially with the amount of users. For example, email is no use if only one person uses it.
Amazon is a good example of a company with strong network effects. As more consumers buy from Amazon, more vendors will look to sell on there. And as more vendors sell on there, more consumers will look to buy there. Once this virtuous cycle takes hold, it becomes the go-to place for consumers and merchants to transact – creating a self-fulfilling feedback loop.
Another closely linked concept to network effects is first-mover advantage. First-mover advantage refers to the competitive advantage gained by being the first occupant of a market segment.
Once the first-mover becomes entrenched in peoples’ mindset, it is very hard to compete with that psychological barrier. Because of network effects, any would-be competitor has to offer something truly unique to attract customers away from the incumbent.
Deep Product Pipeline
Sure, a blockbuster product can lead to a high growth rate for a period of time. But what happens when demand dries up, or a competitor for that product comes along?
To achieve sustainably high growth, a company needs a constant stream of new products to drive sales. The best growth stocks continuously innovate so that they aren’t reliant on one product line.
Moreover, it helps if these products are unique. By offering something differentiated, you stand the best chance of fending off competitors.
Growth Stock Risks
High Expectations
One of the greatest risks for growth companies is the high expectations attached to them. This often leads to exuberance amongst investors, who push the stock price to unsustainable levels.
When the company fails to meet these high expectations, the same investors who were rushing to buy the stock, now head for the exits just as quickly – bringing the stock price crashing back down to earth.
Interest Rate Risk
Another key risk associated with growth companies is interest rate risk. Interest rate risk refers to the negative impact that rising interest rates have on a stock’s valuation.
Remember that a stock’s valuation is equal to the present value of all future cash flows. For growth stocks, most of these cash flows occur far in the future. This is otherwise known as having a high duration.
High duration assets are impacted by interest rate changes disproportionately more than low duration assets. This means that when interest rates rise, the present value of future cash flows declines more rapidly for high growth stocks than low growth stocks.