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Growth Stock Evaluator

Growth stocks are those expected to enjoy above average sales and earnings growth over the next few years. Stocks fitting that bill usually outperform the market in a strengthening economy.

However, whether you got your list from the stocks turned up by the screen, from a TV pundit, or from someone at the gym, consider those stocks to be research candidates, not a buy list.

Here are six tests to help you decide whether your candidates are worth buying. You can find the needed information on many financial sites, including Yahoo’s (finance.yahoo.com) Key Statistics and Analyst Estimates reports.

Not Too Cheap
Cheap stocks, say those trading under $5, are tempting. After all, you could turn $100 into $10,000 if you bought 100 shares of a $1 stock that eventually went to $100. But cheap stocks get that way because many investors see problems ahead. Avoid stocks trading below $5 per share, and, if you want to further minimize risk, up that minimum to $15.

Uptrending Price Chart
A stock’s price action may be your first clue that clued-in players are acting on yet-to-be announced news. A stock is in an “uptrend” when its share price is, despite occasional dips, generally moving up over time. It’s in a “downtrend” when it’s heading the other way. Unless you have contrary information, interpret an uptrending price chart as signaling good news may be on the way, and a downtrending chart warning of bad news.

A stock is in a long-term uptrend when its current price exceeds its 200-day moving average and in a downtrend when trading below. You can see the value of the 200-day MA, which is its average closing price over the past 200 market days, on Yahoo’s Key Statistics report.

The distance between the share price and the moving average reflects the trend strength. For instance, stocks trading at least 20% above the moving averages (e.g. share price is $120 and MA is $100) are in strong uptrends. However, stocks trading at double their moving averages are risky because they have likely gone up too far—too fast. Stick with stocks trading between 10% and 75% above their 200-day MAs. You can see the current value of the 200-day MA in the Stock Price History section of Yahoo's Key Statistics report.

Historical Sales Growth
While the earnings number gets most of the attention at report time, long-term, sales (revenue) growth drives earnings growth.

The best growth prospects have already recorded strong revenue growth. Further, analysts expect them to do as well or better in the future. You can find the historical year-over-year revenue growth figure for the most recent quarter in the Income Statement section of Yahoo’s Key Statistics report. Look for at least 15% historical revenue growth and more is better.

Future Sales Growth
Yahoo’s Analysts Estimates report shows revenue growth forecasts for the current and next quarters, and for the current and next fiscal years. Focus on the fiscal year numbers and look for forecast growth rates at least equal to the historical figures. Up to a point, accelerating revenue growth is even better. Your best candidates will have 25% to 40% expected annual revenue growth. Higher numbers signal risk that the firm will not be able to live up to inflated expectations.

Profitable
Profitability ratios gauge how efficiently a firm is utilizing its assets. The most widely used ratio, return on equity (ROE) compares annual net income to shareholders equity (book value). The way the math works, ROE defines how fast a firm can grow earnings by reinvesting profits rather than resorting to borrowing or selling more shares to finance growth. For instance, a 15% ROE tells you that a company can’t self-finance annual earnings growth faster than 15%.

Require a minimum 15% ROE, and higher is better.  

Valuation
Strong growth stocks get noticed. Eventually, everybody piles on and the stocks get too expensive. Thus, you must check valuation. 

The forward P/E ratio, which divides the current price by the current fiscal year’s forecast earnings (on Yahoo it’s the next fiscal year earnings), is a more realistic comparison of stock price to earnings power. Require forward P/E below 40 (35 on Yahoo) and lower is better.

Use these tests to rule out bad ideas fast. Avoid stocks that flunk any one test. Before you buy, use sites like Yahoo, Seeking Alpha (www.seekingalpha.com), and StreetInsider (www.streetinsider.com) to keep up with news and expert opinions on your stocks. The more you know about your stocks, the better your results.

published 2/12/12

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