The 5 Key Elements You Should Be Looking for in Your Next Growth Stock

It’s a prosperous time to be investing in growth stocks, as the iShares S&P 500 Growth Index (ETF) (NYSEARCA:IVW) is outperforming the iShares S&P 500 Value Index (ETF)(NYSEARCA:IVE) by an impressive 21% to 8% margin.

That’s largely because the market is being led by mega-cap growth stocks such as Facebook Inc. (NASDAQ:FB), Apple Inc. (NASDAQ: AAPL), Amazon.com, Inc. (NASDAQ: AMZN), Netflix, Inc. (NASDAQ: NFLX). and Alphabet Inc. (NASDAQ: GOOG)(NASDAQ: GOOGL), appropriately named the “FAANG” stocks for the first letter of each companies name.

This may have you wondering what you should be looking for in your next growth-style investment.

A rising tide lifts all boats

The one thing all the FANGG stocks have in common is they operate in industries that are experiencing above-market growth. Social media, smartphones, e-commerce, internet search, and online streaming are all growing well above the pace of domestic and global GDP.

Looking for the next big thing?

You may want to consider Tesla Inc. (NASDAQ: TSLA), which is making an aggressive push into electric and self-driving vehicles.

Or you could look to the marijuana industry, which is expected to grow above 20% and become legal next summer; Canopy Growth Corp. (TSX: WEED) and Aphria Inc. (TSX:APH) have outperformed as of late.

You want to find a company that is taking market share from competitors

A growing market is one place to look, but sometimes equally good opportunities can be found where a company is taking market share in a more mature market and outpacing the competition.

Recent examples of this can be found in the case of NVIDIA Corporation (NASDAQ: NVDA) and Advanced Micro Devices, Inc. (NASDAQ: AMD), which have seen their respective shares multiply, while market leader Intel Corporation (NASDAQ: INTC) has languished behind.

Translating opportunity into top-line growth

When investing in growth stocks, it’s absolutely critical that your company operates in a growing market or is taking market share from competitors, as it will ultimately translate to increases in sales, or what’s commonly referred to as “top-line growth.”

Converting growth into profits

If management is doing their job, this top-line growth will translate into growth in your company’s earnings per share (EPS).

If your company employs an ample amount of what’s called “financial leverage,” as is the case with Air Canada (TSX: AC)(TSX:AC.B), it will see its EPS grow by some multiple of its sales growth.

Dividend growth, the ultimate return

Ultimately, as a shareholder, you want to see all that growth translated into dividends that can be re-invested, so you can take advantage of compounded interest.

Be careful with stocks that have high dividend yields; while a high payout today may seem tempting, it will come at the expense of future growth. That’s because a higher dividend today means less cash is retained by the business to reinvest in research and development, capital expenditures, or even mergers and acquisitions.

A company that pays a dividend is telling investors that it has shareholders’ interests in mind, but with growth stocks, you’ll want to see a payout ratio below 35% in most cases.

Conclusion

Much has been made of Warren Buffett and the success of value investing over the past 15 years — a phenomenon which has many in the market chasing their tails lately as the growth style outperforms.

Investing in companies that are growing at an above-market pace will never be out of style. Keep these five key factors in mind when you are looking for that next big stock.

Stay Foolish.