There are plenty of ways how to screen for undervalued stocks using P/E, P/B, EV/Sales or EV/Free cash flow ratios. But how does one find great companies with the potential for long-term growth? High quality growth stocks can deliver staggering returns to shareholders, so it’s a good idea to pay attention to smaller undiscovered companies with new products, services or technologies.
A growth stock investor must examine several important criteria before committing funds to a new opportunity. These were usually present in some of the best performing stocks of the past century, before they took off:
- Strong revenue growth
- Faster earnings or cash flow growth
- High insider ownership
- Large total addressable market (TAM)
- Positive cash flow
- Size of the company relative to its potential
Strong revenue growth
First and most important indicator is strong revenue growth. Company must show increasing sales year over year, preferably at least 25%. Furthermore, an increasing growth rate is an even stronger indicator. For example if the company was growing at 15% p.a. before and it suddenly starts growing at 25%, it’s a good sign that there is strong demand for their product or service.
One word of caution, the company should be growing organically, that is through volume. If a company is selling more and more of its product or service every year, it’s a strong sign that they are doing way better than competition (especially when others are declining).
Growth driven by increasing prices or through acquisitions can usually give only a temporary sales boost to a company. There is nothing wrong with such growth, but it usually doesn’t work out in the long term, especially when it’s fueled with debt. According to estimates, around 50-80% of mergers fail, so chances are against you when you are trying to grow through M&A. Organic growth is a sign of a healthy company and is way more preferable.
High earnings or cash flow growth (increasing margins)
Fast growing companies usually have low or no earnings, as they are investing all cash back into R&D, customer service or marketing. That is a perfectly fine way of operating, but what you are looking for is a decrease in these expenses measured as a percentage of revenue and a corresponding increase in margins. Increasing gross, EBITDA and operating margins are a good sign of improving financials and operating leverage. The best companies are those whose earnings increase faster than sales, as they increase production (economies of scale).
This happens when a company’s costs are largely composed of fixed costs, then as more revenue flows in, costs don’t rise as fast resulting in higher margins.
Here is an example of Amazon’s (AMZN) gross and EBITDA margins over the past 10 years. While it was largely revenue growth that drove the stock price so much, increasing margins also helped a lot.
Another example is Paycom Software (PAYC), which earned a 10% operating margin when it IPO’d, but that later climbed to 30%.
High insider ownership
Companies that are managed by a founder with a large ownership stake generally do better than those with “maintenance” management. Based on Harvard Business Review, those companies where the founder is still actively involved in management (either as CEO, Board chairman or Board member) significantly outperform others.
A single individual can create a strong company culture and motivate employees, which reduces turnover rate and increases their productivity. If we look at the most successful companies of the past like Apple, Microsoft, Berkshire, Amazon, Tencent or Southwest Airlines, they were driven by founders with a strong vision and significant ownership stakes.
You can screen by using the Stockrow insider ownership indicator. Generally insider ownership above 10% is considered good, that is if the CEO owns at least 6-7% of shares outstanding. If insiders are buying the stock, that is a good sign as well. Remember, there are a thousand reasons why people sell a stock, but there is only one reason why they buy it: They expect it to go up!
Large total addressable market (TAM)
The size of the potential market is a key indicator. When a particular company or product reaches market saturation, it’s hard to grow further organically. Instead it starts relying on increasing prices, acquisitions or entry into unrelated fields, which are fraught with peril and historically do not bring good returns to shareholders.
So what you are looking for is a very large and preferably growing market. An example of such markets are e-commerce, business software, medical devices or consumer goods. Sometimes the size of the market is not so clear, as when Uber first came around and the valuation expert Aswath Damodaran estimated the value of the company at $5.9 billion. He arrived at that value by using the total taxi and limousine market as a proxy for Uber’s addressable market. The problem was that it actually expanded way beyond that, as even those people who never took cabs started using the app.
The size of future markets is incredibly hard to predict. For example Ken Olsen, the founder of Digital Equipment Corporation famously said in 1977: “There is no reason anyone would want a computer in their home.” That was back when computers were large, expensive and bulky machines used mostly by businesses to do basic calculations. By 2015 there were more than 1.5 billion PCs installed worldwide, with many of them in households.
If a market is relatively new or growing fast, Wall Street analysts have a very hard time determining its ultimate size, which means that companies functioning in it might be severely undervalued and underestimated.
Positive cash flow
It’s better to own companies with positive operating cash flow, as they have demonstrated an ability to generate cash on their own and no longer have to rely on investors or external financing. This means that the company is less likely to issue additional shares (thus diluting your ownership) or debt, which would decrease earnings in the future.
There are plenty of “hot stocks” with negative cash flow, that promise a big pay off one day. It’s better to avoid those, especially if you are a beginning investor and instead focus on those that are cash positive already.
When a company is burning a lot of cash, it’s hard to tell whether the growth they are generating is adding any value, or if the business model is actually broken. When a founder or CEO has a lot of cash available, it’s hard to be frugal and spend reasonably. When a company is bootstrapped or financed with little external capital, the founders are forced to be careful with every dollar spent and likely to be more efficient.
The market cap does not have to be necessarily small to be a great growth stock. What matters more is that its current revenue is small relative to its addressable market or potential. For example Amazon already did $24 billion in sales by 2009, yet e-commerce was still a small part of the total retail market that is worth trillions. So a company can surpass $1 billion in revenue and still be considered small vs its future growth prospects.
A few closing remarks
Identifying great growth stocks early can bring huge rewards to patient investors. As it’s not easy to find such companies in advance, each growth stock investor is bound to make plenty of mistakes. These are ok, as the winners can deliver gains that can more than make up for the losses. It’s similar to Venture investing, except that you are buying more mature and less risky companies on the public markets. However, it’s not enough merely to identify these companies. An investor must have the necessary courage to buy them and the patience to hold them for years, as they grow from small or unknown businesses to large caps.