Choosing an Early Growth Stage Stock

Written By
Paul Tracy
Updated January 16, 2021

Investing in early-stage growth stocks requires a discerning eye for stocks that present good potential for greater growth compared to other stocks on the market or to stocks that are in the same industry. Although these stocks represent rapid growth and potentially higher returns on your investment, those higher returns also come with higher risks.

But if you’re fortunate enough to invest in the right growth company, the returns, in some cases, can be astronomical in the long run. Don’t forget that Microsoft, Cisco, Dell, Texas Instruments, and America Online were once early-stage companies. Finding these home runs might be a daunting challenge, but it can be done.

However, there are a few challenges that you have to consider when investing in early-stage companies. Mainstream investors, for instance, usually stay away from early-stage companies because of their lack of revenue and profit growth. Plus, the regular debt/equity financing activities dilute the shares and constantly pressure the stock price.

Determining a good entry price for a strong growth stock can be difficult, but it is one of the most important factors in determining success. Ideally, you will buy into a growth company early enough to profit from sustained growth. However, if you pay too much of a premium for the growth potential, you may limit future profits.

Therefore, you need to know how to maximize the odds of long-term success while minimizing short-term risks. There are several characteristics you should look for in a growth stock. The more of these characteristics your potential investment has, the greater the chance it can skyrocket in price.

For one, your chances for success are better if you search for companies whose products and services address big markets. Without a mass market to serve, it becomes far more difficult for any company to grow its business two-, five- or ten-fold. The market could be an old, well-established market, or a new, rapidly developing market. If the company you’re considering operates in an established market, then you must determine whether it’s serving this market in a way that will enable it to boost sales and take market share away from its competitors.

Think of how many companies you know that have served a niche market, yet have grown at remarkable rates for years? I would venture to say that you can’t come up with many.

Another factor which has carried increasing weight with the market in evaluating a company’s growth potential is the caliber of management. In fact, investment companies have paid increasing attention to face-to-face evaluations of management teams in which they are interested. One thing you may want to look for is whether the company has a high insider ownership. It can be an indicator of how much management believes in their own product. History has proved that small caps with good insider ownership tend to perform well over time.

More and more investors have come to realize the importance of a company's research team, particularly if the company is operating in scientific and technological fields. For one thing, organizations willing and able to devote large amounts of time and money to research have generally come out on top over their less research-conscious competitors.

One common measure of growth stocks is revenue, or sales, growth. This is a measure of how fast the revenue has been increasing over a period of time, either on a quarterly or annual basis. New companies in hot industries often see their revenue increase significantly. However, growth naturally slows down as the company becomes larger. And even if its revenue increases, there’s no guarantee that it will make more money.

Besides revenue, the company must be able to generate profits. After all, earnings are everything in the stock market.
But you have to be careful when looking at earnings growth because it can sometimes be misleading. During a particular period, a company may have an impressive earnings growth as a result of a merger or acquisition. When a company is buying another company, the one-time gain makes the numbers look great. What’s more, if the company manages to dispose of some of its equities, it will result in a one-time profits gain.

As a growth stock investor, you should not be overly concerned with day-to-day changes within a company as much as you should be with consistent performance. When a company is performing well, say for six months or more, it’s alerting you to increased sponsorship, as investors bid a stock higher because they perceive the future to be bright. On the other hand, if the stock has consistently underperformed the market in recent months, then your money is better off somewhere else. It could be an indication that something is quietly unraveling at the company, which will eventually erode the stock price.

Admittedly, it is difficult for a company to consistently perform well, especially if it has reached maturity. The math of percentage growth begins to work against the company. It is one thing for a $200 million company to grow 20%—that’s an additional $40 million in sales. For a $20 billion company, that’s an additional $4 billion in sales—a more difficult task if the company is in a competitive market.

Remember, a good growth company will be well-positioned, although not always number one, in its industry with prospects for continued high growth rates. Many growth investors want at least 20% year-to-year increase in revenue with a corresponding increase in earnings, but you will need to find your own comfort level.

No matter what the stock market may be going through at the moment, there will always be some stocks doing well. Even in bear markets, you can find promising growth stocks—you just have to look harder for them.

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