How to Successfully Analyze a Growth Stock
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Bullish markets set the stage for growth stocks to outperform their peers as surging revenue rapidly and earnings growth make it easier to justify high valuations. It’s one of the main reasons the NASDAQ 100 tends to outperform the S&P 500 during periods of economic strength. As a company grows, that once lofty valuation becomes more reasonable, but you still don’t want to pay too much for a growth investment or expose yourself to too much risk.
Analyzing growth stocks can help you find investments that align with your financial goals. Investors who analyze their stocks before purchasing them can also feel more confident during market volatility, a trait that can prevent investors from selling too early. Staying on top of your stocks and monitoring their fundamentals can also help you gain the courage to sell when you believe the company has changed for the worse. Here’s what to know when analyzing a growth stock.
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Start with earnings and revenue
The hallmark characteristic of every growth stock is rapidly growing balance sheets. Profitability is a nice bonus, and you can use a stock screener to filter investment ideas based on profitability, but not all growth stocks start with positive net income. That’s okay initially if revenue is growing at a strong clip and losses are simultaneously narrowing. It means the company will likely become profitable, and strong top-line growth can translate into strong bottom-line growth once it reaches profitability. It’s natural to see why this investment strategy carries high risk, but the growth potential of this asset class can produce generational returns.
Growth investors should look at a few years of earnings and revenue data to gauge if the growth rates are sustainable for a few years or if one year of strong performance is just a blip. A growth stock averaging 500% year-over-year revenue growth for the past five years will experience a significant decline in its revenue growth rate suddenly drops to 20% year-over-year. That growth rate is still respectable, but 20% revenue growth is not enough for companies with high expectations.
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Check the valuation
Any great company can be a bad investment. That’s because many people hear about the investment opportunity and invest in the company. As these investments grow, valuations rise and do not make as much sense for new investors, even if the company continues posting healthy growth rates.
Investors can use several metrics to gauge valuation, but you should never learn on a single metric. The P/E ratio is a time-tested metric for value investors, while the PEG ratio is better for growth stocks. This latter ratio also considers growth when assessing a company’s value to new shareholders. A PEG ratio under 1 can indicate an undervalued stock, but this ratio also assumes the company maintains its current growth rate. Return on equity and book value are two additional metrics to consider, but as you analyze more stocks and look at more valuation metrics, you will discover which ones matter to you the most.
Resources like Yahoo! Finance make it easy to discover stock valuations, but what do those numbers mean? While valuations are arbitrary, finding an undervalued stock with a 50 P/E ratio and an overvalued stock with a 10 P/E ratio is possible. Valuation ratios alone do not tell the entire story, but they paint a better picture when you combine them with earnings, revenue, and comparable companies.
Part of growth stock analysis is knowing the competition. I look at similar growth investments and check their valuations and balance sheets. This research helps me gauge what I will get if I put a dollar into one investment versus a similar choice.
Investors should expect inflated valuations for growth stocks due to their potential. Most people buy stocks because of what those companies can become rather than what they currently are. However, each growth company you use for comparison may need to be more valued. You don’t have to research stocks today until you find a buying opportunity. It’s better to walk away from many stocks and set your standards high, so you’re ready to pounce when the right growth stocks come. You can also filter your search in a stock screener to make these opportunities more likely to appear.
Assess the market opportunity
The growth rate, balance sheet, and valuation can all look good, but some investment opportunities are too good to be true. Assessing the market opportunity can help you discover if you have come across a stock that’s too good to be true or if the growth stock you’re looking at is the real deal.
Buying mutual funds or ETFs focusing on growth stocks can streamline the process. Those fund managers look for compelling stocks, review the market opportunities for each investment idea, and add top picks to their portfolios. However, value is based on the eye of the beholder, and it’s good to assess market opportunities independently. Even if you prefer buying individual stocks, mutual funds and ETFs can be great sources for growth stock ideas.
When assessing a market opportunity, it’s important to know an industry’s total addressable market and the corporation’s penetration into that market. If there is a $100 billion market opportunity, and a stock you want generates $1 billion in revenue, they have penetrated 1% of that market. Competitors will share the total addressable market and fight for more market share, but 1% penetration usually gives corporations more space to grow and provide a capital appreciation for shareholders.
Corporations with greater shares in the total addressable market or ones facing stiff competition may have a harder time repeating strong growth numbers in the years ahead. A competitive advantage is important for any company, but it becomes paramount in vibrant industries with many businesses competing for the same group of customers.
While strong growth can demonstrate success, that success can be short-lived. It becomes more difficult yearly for a company to report strong growth; Meta is a great example. The company once had strong year-over-year growth rates due to its status as a dominant ad player. Many people touted Facebook’s parent company as a reliable and stable investment. Many of those recommendations made sense then, but a staggering ad business and other revenue streams not panning out have contributed to Facebook posting a string of revenue and earnings declines in recent earnings reports. This change of fortunes cut the company’s market capitalization by over half and resulted in unfavorable performance for the company’s stock.
Growth investing advocates should look at current numbers and consider how they can change in the future. The total addressable market may be $100 billion now, but it can become $150 billion in a few years and help companies increase their revenue and earnings with the same percentage of market penetration. Staying in sync with a company’s earnings reports and jumping on their live earnings calls can reveal how a company thinks about its future and ability to access more of the total addressable market.
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Technical indicators can help
When you buy growth stocks for the long term, it makes more sense to focus on fundamental analysis. In this analysis, investors look at the company's valuation, balance sheet, and other components. However, fundamental analysis is not the only way to look at a stock.
Technical analysis uses stock chart movements and historical patterns to predict how a stock price will move in the short term. While technical analysis won’t help you gauge a stock’s performance over several years and its ability to compete with other corporations, it can guide your asking price. Looking at technicals like the 50-day moving average can help investors detect breakouts and reversals before they influence the share price of a growth stock. Some investors set limit orders based on their technical analysis research. You won’t save much money if you make a small investment, but you can save over $100 with this strategy if you make a $10,000 investment.
Let’s assume a stock trades at $50/share, and you have the funds to buy 200 shares. An investor who does technical analysis may find that the stock;’s resistance line recently held firm, a bearish signal. Instead of buying shares at the $50/share market price, the investor uses technical analysis indicators and agrees to buy 200 shares at $49.50/share. The investor waits patiently for the 1% drop in share price and ends up with 200 shares at $9,900. You could use the remaining $100 to increase the shares in your portfolio or put those funds in another investment.
Investors can understand the stock market’s direction in the past few days by looking at index fund charts. They can follow the same process for individual stocks, but technical indicators provide a more accurate but imperfect idea of where the stock could head in the near future.
Stay focused on your financial objectives
Growth investing can yield higher capital gains than value stocks and assets that provide cash flow to their investors. You can combine growth with value, but the high-flying growth stocks often leave a bit to be desired on the valuation front, especially if they have concerns with managing liabilities.
Growth stocks are risky assets but can be incredibly rewarding if you find the right investments, reinvest, and hold onto them. Before getting into growth stocks or any investment, you should identify your financial objectives and how you will get there.
Retiring isn’t just about picking the right stocks. You also have to preserve your wealth and increase your monthly contribution. The monthly contribution is the only thing you can control, and making more money makes it easier to ride volatility and buy dips. Knowing your financial objectives can also help you clarify how much you need to put into growth stocks. For some investors, a 20% concentration in growth stocks makes sense, but others may seek a lower concentration to manage risk, especially as these investors get closer to retirement. Risk-averse investors can combine value investing with growth investing to make investment decisions that align with their long-term goals.
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Marc Guberti is a business freelance writer who specializes in personal finance, digital marketing, and entrepreneurship. His award-winning book "Content Marketing Secrets" teaches readers how to create, promote and optimize content for growth and revenue. Marc also hosts the "Breakthrough Success Podcast," where listeners learn how to master content marketing and get more clients.
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