If you are an investor and willing to put your money in the stock market, there are certain things you should keep in mind before leaping purchases. In this blog, we are going to discuss how to identify the growth stocks for your portfolio.
What is a Growth Stock?
A Growth Stock is a stock of a company that generates substantial positive cash flow and its earnings and revenues are expected to increase at a faster rate than the average company within the same industry.
Generally, a growth stock does not pay any dividend and reinvests the retained earnings as capital for profitable projects. These are the technically advanced companies that hold patents. Investors pick growth stocks as they offer a potential for huge capital gains. But they are risky too as they have an equal probability of upside and downside potential. Some of the examples of Indian growth stocks are Bajaj Finance, Alkyl Amine, etc. Let us find out how to identify the growth stocks.
How to Choose the Best Growth Stocks?
- Increasing Sales
In some cases, a company may not show very high profits but has good sales. The best example is Eicher Motors. Find out such companies as they have a good potential to perform once they take off.
- Upward Trend in Earnings Growth
The EPS of Earnings per Share of a company is an indicator of how profitable a company is. An investor would like to invest in a company with an upward trend in EPS as it is capable of offering a high investment return.
- Return on Equity
Return on Equity comes is one of the most important criteria used by Warren Buffet for evaluating companies. ROE is equal to net incomes as a percentage of shareholder’s equity. A company with high or increasing ROE as compared to its competitors uses its capital more efficiently to generate profits.
- Balance Sheet
A strong balance sheet is defined as one with low debt over a good cash position. Liquidity is an essential factor for the growth of a company. Many companies expand quickly and later realize that they do not have enough liquid cash to settle the debt and borrowed capital used for the growth of the company. Such companies focus on repayment and not growth and are under the constant fear of winding up due to insolvency.
- Strong Cash Flow
Strong cash flow is a sign of high sales turnover or the sale of the company’s subsidiaries, heavy machinery or overseas branches. A company with a lot of free cash flow is a target for high dividend seekers and the investors expect payment out of this free cash. Whereas, growth stock companies are low on free cash as it is usually converted into capital expenditure for the growth of the business.
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A smart way to inspect a growth stock is to check its operating cash flow and not the free cash flow. Increasing and consistent operating cash flow is a good sign that the company is getting new money from capital expenditure.
- Dividend Payout Ratio and Retained Earnings
A growth stock company usually has a dividend payout ratio of 50% or lower. The dividend payout ratio is the return paid to shareholders based on the net income of the company using dividends. The amount held back for reinvestment and growth by the company is called retained earnings.
A growth stock company keeps all the gains to diversify or expand the business. An established business prefers to share its gains with its investors.
- Growth Track
Each company leaves a story of its progress or success behind. A growth stock company is expected to have a trail of tangible growth in the past 3-5 years. Carefully study the company records for profits, cash flow, sales, and rising revenue. Many companies boast of big numbers and profits and get trapped in scams. A wise investor doesn’t fall into the trap of promising words like growth, expansion, and high growth and always checks for the stable growth of a company over a period.
Pro Tip – Identify small and mid-sized companies as they come with prospects for higher growth. These stocks are not very high on liquidity and offer the retail investors a good opportunity to own the shares of the company before it grows. An established company believes in giving back to its investors and offers dividend-centric investment.
As a smart investor, you must know how to identify the growth stocks for your portfolio. As India is the fastest growing economy in the world, there is a pool of profitable companies for investors. A growth stock can appear in any form – a mature company or a start-up that is on the verge of a breakthrough.