How to Find Growth Stocks with Strong Fundamentals: A Practical Guide

Before we dive into the “how,” let’s clarify the “what.” A growth stock belongs to a company that is expected to grow its revenue and earnings at a significantly faster rate than the average company in the overall market. These are often innovative companies, disrupting industries and rapidly expanding their market share.

Think of it like this: if the stock market as a whole is a marathon runner, maintaining a steady, respectable pace, a growth stock is a sprinter, bursting ahead with explosive speed.

This is fundamentally different from a value stock, which is a company that the market appears to be under-appreciating. A value investor looks for a stock trading for less than its current intrinsic worth—a hidden gem. A growth investor, on the other hand, is willing to pay a premium for a company’s future potential, betting that its rapid expansion will lead to outsized returns.

To identify these potential sprinters, our primary tool is fundamental analysis. This is the process of examining a company’s financial health, competitive position, and economic environment to determine its intrinsic value and long-term potential.

For growth stocks, our use of fundamental analysis is slightly different. While a value investor uses it to find a discount on a company’s current worth, a growth investor uses it to validate a company’s future growth story. Are the company’s ambitious plans backed up by solid evidence? Fundamental analysis helps us answer that.

The numbers tell a story. For growth stocks, you need to know which chapters are most important. Here are the key quantitative metrics that signal a company with a strong growth trajectory.

Strong, consistent revenue growth is the lifeblood of a growth stock. A company can’t grow its profits over the long term if its sales are stagnant. Look for companies that are consistently increasing their top-line revenue, preferably at a double-digit percentage year-over-year.

• What to Look For: Annual revenue growth of at least 15-20% over the last few years.
• Red Flag: Be wary of growth that comes from a single, large acquisition rather than organic growth from the company’s core business. While acquisitions can be good, organic growth is often a better sign of a company’s health and desirability of its products or services.

Earnings Per Share (EPS) represents the company’s profit allocated to each outstanding share of common stock. Strong EPS growth shows that a company is not just increasing sales, but is also managing its costs effectively and becoming more profitable as it scales.

• What to Look For: Look for a consistent history of annual EPS growth. Accelerating growth is an even better sign.
• Red Flag: Watch out for companies that manipulate EPS through excessive share buybacks. While buybacks can be a sign of confidence, they can also artificially inflate EPS without any underlying improvement in the business’s profitability.

Profit margins (net margin, gross margin) tell you how much profit a company makes from each dollar of revenue.Expanding margins indicate that a company has pricing power and is becoming more efficient as it grows. It’s a sign that the growth is sustainable and not just being “bought” at the expense of profitability.

• What to Look For: Stable or, ideally, expanding profit margins. Compare a company’s margins to its direct competitors.
• Red Flag: Declining margins can be a serious warning sign that competition is heating up or the company’s expenses are spiraling out of control.

Return on Equity (ROE) is a powerful measure of a company’s quality. It calculates how much profit the company generates with the money shareholders have invested. An ROE of 15% or higher suggests that the management team is excellent at deploying capital and creating value for its shareholders.

• What to Look For: A consistent ROE of 15% or more.
• Red Flag: An unusually high ROE can sometimes be the result of high debt levels. Always check a company’s balance sheet to ensure its debt is manageable.

Financial metrics are crucial, but they don’t paint the whole picture. The most durable growth companies have powerful qualitative advantages that numbers alone can’t capture.

Coined by Warren Buffett, an economic moat refers to a company’s ability to maintain its competitive advantages over its rivals to protect its long-term profits and market share. What makes this company difficult to compete with? Sources of a moat include:

• Network Effects: The product becomes more valuable as more people use it (e.g., social media platforms).
• High Switching Costs: It’s too expensive or inconvenient for customers to switch to a competitor (e.g., enterprise software).
• Intangible Assets: Patents, brand recognition, or regulatory licenses that block competition (e.g., pharmaceutical companies).
• Cost Advantages: The ability to produce goods or services at a lower cost than rivals.

A visionary and effective management team is often the driving force behind a great growth company. Look for leaders with a clear vision for the future, a track record of excellent execution, and significant ownership stakes in the company (skin in the game). Read their shareholder letters and listen to earnings calls to get a sense of their strategy and transparency.

A company can’t grow if its market is saturated. The Total Addressable Market (TAM) is the overall revenue opportunity for a product or service. You want to find companies operating in a large and, ideally, growing market. This provides a long runway for future growth.

Growth stocks often look expensive. Their Price-to-Earnings (P/E) ratios can be sky-high, scaring off many investors. While you should be wary of extreme valuations, using traditional metrics alone can be misleading. Here are two better tools for the job:

The Price/Earnings-to-Growth (PEG) ratio compares a company’s P/E ratio to its earnings growth rate. It’s calculated as: PEG Ratio = (P/E Ratio) / Annual EPS Growth Rate.

A PEG ratio of 1.0 is often considered fair value. A ratio below 1.0 may suggest the stock is undervalued relative to its growth, while a ratio significantly above 1.5 or 2.0 might indicate it’s overvalued, even for a growth company. It provides much-needed context to a high P/E ratio.

What about brilliant, fast-growing companies that aren’t yet profitable? For these, the Price-to-Sales (P/S) ratio is more useful. It compares the company’s market capitalization to its total revenue. While there’s no “magic” number, it’s best used to compare a company’s valuation against its own historical levels and against its direct competitors.

Feeling ready to start your research? Use this checklist to guide your analysis of any potential growth stock:

• The Growth Story: Is the company growing revenues and EPS at over 15% annually?
• Profitability: Does it have stable or expanding profit margins?
• Quality: Is its Return on Equity (ROE) consistently above 15%?
• Competitive Advantage: Does the company have a durable economic moat?
• Leadership: Is the management team experienced, transparent, and invested?
• Market Opportunity: Is the company operating in a large and growing Total Addressable Market (TAM)?
• Valuation: Is the PEG ratio reasonable (ideally under 2.0)? Or is its P/S ratio justifiable relative to its peers?
• Financial Health: Is the company’s debt level manageable?

By focusing on companies with strong and accelerating sales, consistent profitability, a clear competitive advantage, and visionary leadership, you shift the odds in your favor. Remember to always consider valuation—even the best company can be a poor investment if you overpay.

This guide has provided you with a map and a toolkit. The next step is yours. Begin your research, analyze companies with a critical eye, and build a portfolio based on quality and potential, not just hype. Your journey as a discerning growth investor starts now.