Find growth stocks at the right price

By Harry Domash

Most investors whom I talk to are growth investors, meaning they look for stocks with rapidly growing sales and earnings. The reason is understandable: Rising sales and earnings usually drive share prices higher.

Unfortunately, that relationship is hardly a secret. Fast growers attract attention, and then everybody jumps on the bandwagon, driving up share prices to unsustainable levels. All too often, by the time we discover a growth stock, it's too late to join the party.

Thus, successful growth investing requires finding stocks with solid growth prospects that still have room to run.

Using MSN Money's Deluxe Screener, I'll show you how to find fast growers that, although hardly unknown, are still attractively priced. Initially, the screen isolated reasonably priced stocks with strong recent and expected sales and earnings growth. Then it ruled out the highest-risk stocks in the bunch -- companies that are too small, are unprofitable, carry high debt or are shunned by big, in-the-know investors. Finally, the screen selected stocks with strong price charts from the list of survivors. Here are the details:

The ante: Fast growth

I used the most recent fiscal year's growth and the current and next fiscal year's growth forecasts to define my universe of growth stocks. Many experts look further back and require stable earnings growth going back, say, five years to qualify. Doing that, however, disqualifies newer firms, which, I've found, are usually the fastest growers.

Though any stock with annual earnings growth in double digits technically qualifies as a growth stock, those with sales and earnings growth of at least 20% annually make the best candidates. So I started by applying those minimums to the past fiscal year's sales and earnings growth.

Screening parameter: Revenue Growth Year vs. Year >= 20

Screening parameter: EPS Growth Year vs. Year >= 20

Next, I required at least 20% expected annual earnings growth for the current and next fiscal years.

Screening parameter: Current Year Growth Rate >= 20%

EPS Growth Next Year >= 20%

Not too cheap, not too expensive

Though it's important to avoid growth stocks that have already been driven to unrealistic levels, it's equally important to avoid stocks that are too cheap.

Valuation ratios such as price-earnings (recent share price divided by 12 months' earnings) are, in reality, market-sentiment gauges. High valuations tell you that market players are excited about a stock's growth prospects. By contrast, low valuations define out-of-favor stocks that many investors are avoiding, probably because they see problems down the road.

Successful growth investing requires picking in-favor stocks. It's the market's enthusiasm that drives up their share prices. Conversely, stocks that look good otherwise but are trading at low valuations almost always disappoint.

Thus, worthwhile growth candidates must not be overvalued but shouldn't be too cheap, either. I'll use two ratios -- forward P/E and price-sales -- to ensure that we get stocks that are just right in terms of valuation.

The forward P/E is the price-earnings ratio based on analysts' forecast current fiscal-year earnings instead of the actual reported last 12 months' earnings used to calculate the standard P/E. I use forward P/E because the forecast earnings exclude one-time charges that artificially reduce earnings and distort P/E ratios.

Forward P/E ratios below 20 signal out-of-favor stocks, which we want to avoid. Conversely, though there's no hard and fast rule, I've found that stocks with forward P/Es much above 35 often disappoint. So, I look for stocks with forward P/Es between 20 and 35.

Screening parameter: Forward P/E >=20

Screening parameter: Forward P/E <=35

The price-sales ratio is similar to P/E except the recent price is divided by 12 months' per-share sales instead of earnings. The price-sales ratio is a steadier measure than P/E because sales fluctuate much less than earnings from quarter to quarter.

Price-sales ratios of 2 and below usually signal out-of-favor stocks. I picked 2.5 for my cutoff. On the other end, stocks with ratios of 8 or higher are probably in over-hyped territory. Consider reducing the maximum to 6 or 7 if you want to further reduce your risk.

Screening parameter: Price/Sales Ratio >=2.5

Screening parameter: Price/Sales Ratio <=8

Only 45 stocks passed these tests.

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