When it comes to investing, the options are becoming countless. The list of investment vehicles is long and varied, with opportunities in mutual funds, stocks, bonds, ETFs, crypto, REITs, and so on readily available for you to choose from. However, different factors go into making a sound investment within each category.
The key is finding an option that will match up well with both your financial goals and personality quirks--it's about finding what works best for you at this stage in life.
While an older investor, or one who should not risk their money, will look for something more stable and safe with a return that's guaranteed - an investing beginner with plenty of time to generate income could keep their eyes open to investing in growth stocks. These stocks are intriguing because of their potential for big profits, but they're also highly volatile; they have the capacity to go up dramatically in value but may drop just as rapidly.
The first step in investing your money is investing your time--learning about the different types of investments, what risks you should be prepared to take, and whether investing in growth stocks is a good investment for you. As the team at StockFam likes to say, you must “know what you own” and build conviction based on your own due diligence.
As a growth-oriented investor myself, I'll offer a beginner's guide to growth stocks and steps to evaluate them to find the right fit for your portfolio.
A growth stock is essentially a company that can grow revenue and earnings year after year compared to other companies in its market niche. The idea is that as a company grows, so does its stock price. For those who are risk-averse, investing in growth stocks may not be the best method for long-term wealth accumulation. It's also important to note how this type of investment differs from income investments like bonds and dividend stocks.
If you're looking for income, then you'll want to look at the potential yield rather than the growth outlook. Growth stocks are designed with long-term wealth accumulation in mind, so they'll typically have lower yields when compared to other investment options. This is why it's necessary to closely review all parts of an investment before pulling the trigger on a purchase.
Risks with high-growth stocks are not to be taken lightly. Before investing, you must understand the risks in order to minimize your chances of losing money on a wrong decision. Some of the most common risks include:
Sector Risk
You'll want to select a sector before investing in a company. Some sectors tend to be more volatile than others, so you'll need to know which direction the industry of your choice is trending and its projected growth rate.
Competition
Businesses that are growing quickly typically become targets for competitors looking to grab market share. If you're hoping to avoid investing in a stock that is easy to mimic, then growth companies may not be for you.
Growth Can Slow
Even if a company is growing rapidly, there's always the chance it will become saturated and no longer continue at its current pace--and even shrink in size. This scenario is known as market saturation and can lead to a significant decrease in stock price.
Irrational Thinking
When growth stocks take off, you can find yourself subject to the emotions associated with the hype surrounding them. If you're prone to making bad decisions under pressure or buying into the hype, then these types of investments may not be suitable for you.
Economic Landscape
Keeping an eye on the macroeconomic trends of the country is another considerable practice. Some important questions to ask include: Is the economy expanding or contracting? What is the interest rate environment like? What are the initiatives of the current administration? Is GDP growing? What type of investing is popular (i.e., what are people investing in)? How healthy is the job market? Many things can impact the sentimentof the market, so it remains vital to stay on top of it as things evolve.
As with any investment, there are many risks you will encounter. But if you approach investing with a level head and do your homework, then this may be the type of investment that can help you reach your long-term financial goals.
Let's dive into how to find and evaluate an investment for your portfolio.
As with any investment, it's vital to do your homework before purchasing a growth stock. To properly vet a stock, you'll need access to all parts of its current business health and financial history.
A moat is a concept used in investing to describe how difficult it would be for another business to enter the same niche. If you're investing in growth stocks, then this should be one of your top investing criteria. You want to find companies that offer products or services that are unique and not easily replicated. It's also vital that these companies have a competitive advantage. Examples of competitive advantages include cost-effectiveness, niche market focus, high barrier-to-entry, and high customer loyalty.
Truly successful investing is about believing in the underlying company to increase its value over time, which means finding great management teams associated with the business.
Will they deliver growth and create long-term shareholder value?
For a public company, it's effortless to find out who makes up the board members or senior leadership team. Do some digging online and read between the lines to get an idea about management's vision for growing their business or if they'll be able to manage it well from both a financial standpoint and execution capabilities.
Have they worked in similar markets before? What was their experience scaling a business and hiring the right team rapidly? Do they create a great culture and business environment? In addition, what is their vision for the future of their company? Do they have a clear plan to scale (i.e., increase sales)? Or will they be able to penetrate new markets?
Moral of the story: In this race, betting on the jockey is just as important as betting on the horse.
Many people tend to make investment decisions based on the present day. They want assurances that they will see a return on their investment now. However, growth stocks require investors to keep the future in mind and predict the business of tomorrow. This is especially important with investments in technology and consumer goods as they tend to have shorter lifespans for ever-evolving tastes among consumers.
For example, if you were investing in Apple during the early 2000s, it was important to recognize that computers would start integrating within households at an accelerating pace. While they are still a fantastic company today, the returns of those who understood the power of the Macintosh computers early on, benefited much greater than those who entered five or ten years later, as computers became a must-have.
Investing in something that isn't completely proven may be worth it if you come across a well-managed, unique company in a young market that has the potential for significant expansion and demand.
While many growth companies may not produce a large profit or any at all early on, a sound investment you follow should have a clear path to profitability. For example, if a company is investing in new technologies and expansion of its product offerings, it could expand the scope of its business while adequately managing expenses to keep margins high.
Amazon, a well-known example, was not profitable until about six years into their business as it continued to innovate and pour incoming revenues back into its technology to scale. However, once the investments were made and the industry had a chance to mature, the company had more efficient costs of operation compared to other companies, allowing it to be far more profitable than its competitors. Learn where your business is spending its money and understand if those costs can scale with the company's growing revenues. Once you understand that, then you'll be investing in a growth business.
You'll want to look at the liquidity of a stock before investing in it. Liquidity refers to how quickly you can sell a stock without suffering from a significant loss in value. For growth stocks, this is especially important if you don't plan to hold onto the stock for an extended period of time.
To evaluate the liquidity of a stock, you can look at its daily volume and variation in price over the past year. Share structure simply refers to the number of shares outstanding and preferred stocks owned by insiders. If a company has more shares, it's potentially diluting the value of its stock while attempting to raise money. Therefore, low liquidity and share structure are critical red flags that you should avoid investing in.
Instead of just jumping into some of the metrics for evaluating a potential investment, let's review some of the sources you'll use to find the data necessary to perform the calculations.
All of the numbers presented below can be found in the financial statements provided by the company in each earnings report: the balance sheet, the income statement, cash flow statements, and the statement of retained earnings.
Income Statement
This provides a source of financial information about a company's income or revenue that has been generated over a particular period of time, typically for the past 3-12 months. The Income statement is essentially the "report card" for the business in that it summarizes its performance in three categories: revenue, cost of goods sold (COGS), and gross profit.
Balance Sheet
This gives an overview of all assets, liabilities, equity, and capital employed by a company. It's meant to be used in comparison with other companies in the same industry.
Cash Flow Statement
Offers information on the total and/or per-share earnings of a company over a certain period (typically 3 months, six months, and one year) in three key areas: investing activities, financing activities, and operating activities.
Statement of Retained Earnings
This statement documents all changes in retained earnings for a particular fiscal year — that is, what's earned and given back to shareholders. This amount also reflects the earnings of a company from business operations and any distributions from investing activities, financing activities, and investing/financing combinations.
Here is where some investors begin to lose patience. Evaluating and putting in the effort to understand a company's financial statements takes work. However, it should be one of the first items on your list. You want to learn as much as you can about the most current financial statement.
It is key to research the most recent quarterly earnings report and listen to the conference call (if available). A quarterly earnings report should be viewed as its report card revealing its performance over the past quarter and should be compared to the year(s) prior.
Revenue growth & Forecasts
Check a company's revenue growth over a period of several years. Typically, you'll want to look at five years worth of data for this step. If the trend line is rising, it can be a great indicator that the company is poised for future growth.
Growth stocks typically have aggressive sales forecasts due to their nature. When you're looking at projected revenue growth, look for companies that are reaching high targets. If a company is shooting for double-digit growth year after year, it's probably worth investigating further.
As a general rule of thumb in investing, a high price in relation to earnings is a sign of an overvalued company. So when looking at stocks, you'll want to make sure that their share price isn't significantly higher than other companies in the same sector.
Of course, there are exceptions to this rule--a growth stock may be extremely expensive due to its strong financials and market trends. However, if no similar companies can be found with the same valuation, then it's probably worth locating the most comparable business models out there.
Using the valuation tactics below you can understand a company's efficiency and compare it to its industry average and top 3-5 competitors, gauging its value accordingly.
(*Using the StockFam™ Financial Calculator, you can run your own analysis to quickly analyze and evaluate a stock you are interested in)
You'll want to look at a company's earnings per share (EPS) and price-to-earnings ratio (PE). If EPS has been consistently increasing while maintaining a low PE relevant to its competitors, then it may be a good investment opportunity. However, if earnings and PE metrics are declining, then you'll want to look elsewhere.
EPS and PE are calculated using the following formulas:
EPS = Net income/Total shares outstanding
PE = Current price/Earnings per share
Despite the fact that a P/E ratio is a great indication of a maturing company's value, growth stocks are typically valued based on recent and future growth rates, making a PEG ratio (see below) a more indicative figure for this type of investment.
Price/earnings to growth, or PEG, calculates a company's PE as it relates to its expected earnings growth. If the investing community is projecting a high rate of return on investment (ROI), then the stock may be viewed as undervalued. However, if expecting a lower return on investment, then it should be viewed as overpriced.
Price/Earnings-to-Growth is calculated using this formula:
PE Ratio divided by the company's growth rate for the past one, three, or five year(s).
A high-growth stock might have a high PE ratio, but if it's not increasing its earnings, then you'll want to look elsewhere. A company's profit margin (PM) is the ratio between its net income and total revenue. Evaluating a company's PM can give you a better idea of how profitable it is. A company with a PM greater than 20% is typically considered in the upper half of its industry.
Profit Margin is captured using the following formula:
PM = Net income/Total revenue
Gross Margin (GM), which is the ratio between a company's total revenue and cost of goods sold, tells you how much a company makes as a percentage of its sales. A stock with high GM is typically considered to have strong pricing power. This differs from Profit Margin in that GM does not take into account operating expenses.
GM = Total revenue/Cost of Goods Sold
You'll want to make sure that a high-growth stock's ROE is not only positive but also healthy. For example, a company with an ROE of at least 20 is a great indicator that the company is investing its money wisely. Conversely, if a high-growth stock's ROE is less than 20, then you'll want to be cautious investing in it.
Return on Equity (ROE) is calculated using the following formula:
ROE = Net income/Total equity
Return on capital employed (ROCE) is a way of assessing how effectively a firm uses its money. It shows the efficacy of a company's resource allocation. For example, a high ROCE indicates that there has been significant growth from investments, whereas a low ROCE may suggest that the capital investment strategy is ineffective.
ROCE differs from ROE in that it considers the amount of capital employed as an indicator of how to invest money. On the other hand, ROE looks at earnings from operations and net income after considering all non-debt financing (i.e. cash and equity).
Return on capital employed (ROCE) is calculated using the following formula:
ROCE = EBIT/Capital Employed
This helps give you an idea of the growth potential in the sector. It is particularly useful for companies that are not yet profitable, as it reflects sales performance rather than profitability.
You may want to stay away from stocks with very high P/S ratios, which indicates that they are investing in marketing more than research and development or other critical areas of the business.
The price-to-sales ratio (P/S) is calculated using this formula:
Price to Sales = Current stock price/Annual Sales
The debt-to-equity ratio will help give you an idea of whether a company is making smart investments or not. The lower the debt-to-equity ratio is, the better. Before investing in a high-growth stock, you'll want to make sure it has a low debt-to-equity ratio. If you're investing in a business that isn't profitable, it may be a sign that the company isn't investing its money wisely. A debt-to-equity under 0.4 is considered a powerful indicator, whereas anything higher than 1 means that the company's debt outweighs its Equity.
Debt to Equity is calculated using the following formula:
Debt to Equity = Debt/Equity
The quick ratio is a simple but effective way of determining how liquid a company's assets are. The higher the quick ratio, the more profitable and well-managed a business is. It shows that a company can meet its short-term obligations with its cash reserves or inventory items. A quick ratio under 0.9 means that it might have some difficulty when it comes to meeting its short-term obligations.
Quick ratio = (Current assets - inventory) / Current liabilities
A business's book value per share is a simple way of finding out what the company is worth. This metric tells you how much each share of stock should be worth, which is very useful when investing your money. For example, if Book Value Per Share increases over time, then that means that the investing company is investing its money wisely and is becoming more profitable.
A company's book value per share is calculated using this formula:
Book Value Per Share = Total assets - Intangible assets - Preferred stock - Goodwill / Number of shares
A high-growth stock may have a few years until it becomes profitable, so investing in that type of stock might not be ideal. You'll need to ensure that the investing company has enough cash flow to make it through its lean years. If you want to invest in a high-growth stock, investing in one with positive cash flow is ideal.
Cash Flow is calculated using this formula:
Cash Flow = Net Income + Depreciation - Capital Expenditures
Last but not least, before investing in stocks, you'll want to know what the company's market cap is. Market caps are different depending on the industry, so if you know which sector you are interested in, you can find the average market cap for that industry on investing websites.
Investors' equity is also worth noting. This represents how much value investors put into a company in exchange for stocks or bonds they buy from the company. In addition, investors' equity typically increases over time, which means that investors are investing more money into the company.
Market capitalization can be calculated using this formula: Market Capitalization = Current stock price/Number of shares outstanding
Investors' equity is calculated using this formula:
Investors' Equity = Total liabilities - Preferred Stock + Common Stock - Treasury Stock
Reviewing all of this information may be overwhelming for beginners, but the more you know, the better your investment choices will be. Hopefully, this guide has given you a little insight into what to look for when investing in growth stocks and how to manage your money effectively. If investing is something that interests you, studying up on investing basics can help prepare you for more advanced investing tutorials that are sure to come your way.
As always, thank you for reading! Best of luck, and see you in the markets!
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