Editor’s Note: Stocks are on a tear this year, and growth is in the spotlight once again. So we thought it was prudent to highlight this past essay from Adam. If you want to know what good growth looks like, and how his proprietary Green Zone Power Ratings system finds it, read on…

I’ve written before about how I use the Value factor in my proprietary Green Zone Power Ratings system to identify cheap stocks without getting sucked into a dreaded “value trap.”

And one of the best ways to do that is to also focus on a company’s growth. I use the Growth and Quality factors within my system to help me weed out stocks that look like good values at first glance.

So today, let’s take a deeper look at my Growth factor’s role in the equation.

You might be wondering: What is growth?

When I speak of growth, I’m not referring to a stock’s price. I’ve created three specific factors that analyze that — Momentum, Size and Volatility.

My Growth factor is focused on a company’s fundamentals. It measures the rate of expansion for revenues and profits.

We’re looking at the prospects of the underlying business.

And it tells us a lot about where the company — and its stock — are headed.

Why Growth?

Let’s start with the basics.

When you buy a stock, what are you purchasing?

Let’s be serious: You and I aren’t going to sit on the board of directors, and we have no control over the company’s assets.

We’re passive investors. When we buy shares, we’re buying a fraction of the company’s future earnings. (And as my friend Charles Sizemore likes to point out, potential for a stream of dividends too!)

If you want a rising stock price over time, you need a growing business to support it.

If you’re looking for a healthy dividend check to hit your account each quarter, you need a growing business to support it. If you want to stay ahead of inflation … you get the idea.

How I Measure Growth Stocks

In Green Zone Fortunes, we look for stocks that we can hold on to for a while.

That means I’m not going to base my decision to add a new monthly recommendation on a single quarter or even a single years’ worth of sales or earnings growth. There can be a lot of noise in short-term data.

Growth can vary from quarter to quarter, or even year to year, based on where we are in the economic cycle. We’re looking for consistency with a long history of growth.

I can’t give you the secret sauce, per se, but I can give you an idea of what I’m talking about.

My Growth factor is a composite score made up of 18 subfactors. I look at growth in revenues, net income and earnings per share. And I use a variety of time frames, ranging from a single quarter to 10 years.

It might seem redundant to track revenues, net income and earnings per share, but each has its place.

It starts with top-line revenue growth.

A company cannot sustain profits unless it grows its sales first.

Sure, cutting costs can boost earnings, even with flat or declining revenues — but only for a while. For sustainable earnings growth, you need a growing revenue stream supporting it.

All the same, revenue growth in the absence of earnings growth is nothing to get excited about. In fact, if revenues grow but net income doesn’t, that can be a sign of a company facing cutthroat competition and declining profitability.

We want net income to grow at least in tandem with revenues over time.

What about earnings per share (EPS) … and how is that different from net income?

We calculate EPS by dividing net income by the number of shares.

If the company’s share count is stable, earnings per share should rise in line with net income.

But share counts are not always stable. Companies issue new shares via secondary offerings or executive stock options, and they reduce their share counts with buybacks.

If I see EPS growing at a much slower pace than net income, that could be a sign of excessive share dilution and would make me think twice about buying the stock.

Growth Isn’t the Only Key

I’m a growth investor, and I love the challenge of looking for the next big mega trend. But I also know that investors can and often do overpay for growth.

And this is where we come full circle back to value. By considering my Value factor alongside my Growth factor within Green Zone Power Ratings, I can target growth at a reasonable price.

If you like the way I approach investing, give my premium newsletterGreen Zone Fortunes a read.

In each issue, I use the market-crushing combination of Value and Growth (along with my Momentum, Size, Volatility and Quality factors), mega trends with true staying power and an X-factor that other investors are overlooking to recommend stocks that can outperform — no matter what the market is doing.

Click here to find out more and join us before I send out my next high-conviction recommendation later this month.

To good profits,

Adam O’Dell
Chief Investment Strategist, Money & Markets