Another solid guest post from a trading challenge student:
Growth stocks are great to trade because they normally move in large percentages like 5% and higher. Then on occasion you see a big change in the share price that can make you a ton of money. Growth stocks should be followed by every trader, especially when they start hitting their occasional peaks. Finding these stocks are fairly easy because you can see them mentioned in many articles, but there are a few other things you can look at to decide.
Brand New Technology
A lucrative new technology is part of most growth stock stories but not all. You can have a new company in an established but lucrative field that has a minor competitive edge can also be a growth stock. This is not something you can scan for, but a lot of these hot new technologies are covered even before the companies in them are public.
Brand new technologies tend to be unproven, and growth companies spend a lot of money on development and ramping up production. There can be a lot of swings related to operations and sentiment. A new production facility goes online, or one goes down. All these things can have an impact on the stock. This is probably one of the more fun things to research since you can read about brand new gadgets or technologies that used to be science-fiction. Rarely are things interesting from a non-trading perspective. Earnings have their moments, but are not really casual reading.
Download the key points of this post as PDF.
Insane PE Ratios
You can have a high PE ratio and not be a growth stock. I would put Amazon in this category, when it is making a profit. Amazon is still kind of a growth stock, but it is just too much of a leader to be considered and up and comer.
Most growth stocks that have positive earnings have very high PE ratios, because the expectation is that growth will be growing at a very fast rate and it will catch up. It also makes sense for companies on the cusp of realizing all the gains it has been working toward. A company has worth beyond its earnings. A company with a robust balance sheet has value even if it is only has earnings of $0.01. That would most likely give it a very high PE. You have to balance intrinsic value against the money the company makes.
Then there is the even harder concept of future potential. That has to be priced in, usually it comes in a bit high. As a trader you can jump in when the initial sentiment starts. Growth stories can play out over years so you just have to trade them like normal. However, there are times when the story has some cracks.
Growth Story is not so Strong
Growth stories will hit a speed bump. If insane growth continued nonstop there would be an endless slew of bigger and bigger companies, and everyone would be rich or rather they would have large bank accounts if they invested. Growth stories eventually fizzle and since the market tends to swing like a pendulum the end of perceived growth can have a significant downward impact on the stock. You can see an example of this with VMWare.
Some growth stories end with events like the dot com bubble or the financial crisis, but others just peter out. VMWare just said that growth was slowing for a year and it was hit with an almost 30% decline most of it taking place in a day then slowly drifting for the next few months. Opportunities abound in growth stocks, and they tend to be more volatile even when they are in a holding pattern.
Usefulness of the PEG Ratio
The PEG Ratio, or the price to earnings growth ratio, gives you a picture of the current price in light of the estimated growth of the company. The estimates really throw a kink into the works. The estimates are usually for five years, but there are other measures. However, since they amount to guesses they need to be taken with a grain of salt.
The PEG is championed by some and there are many quantitative studies to both prove and disprove its usefulness. In reality it is one of the things that can be looked at for a final push. A growth stock is all about growth. A high PE might not matter if the company is expected to grow and a high PE and a low PEG ratio can mean that a company is undervalued relative to its growth. Even if they are estimates people can be looking at the ratio. It is just one more thing in the bag of tricks that traders can use. A large divergence in how the market is treating growth versus the estimates can be a guide to future sentiment, especially if the company incrementally delivers.
Revenue Growth over Earnings Growth
Another way to screen for growth stocks is to look for high revenue growth on a YoY or sequential basis. This is probably the least useful, because it can create a lot of false positives. However, it does highlight how early stage companies are all about revenue and not necessarily profit. There are a lot of reasons for this. Building market share can be one of the most important. Economy of scale takes a certain level of production to reach and the company might be headed toward this, but until then profits will remain under pressure. Revenue is what most growth stocks focus on.