6 Companies With the Best Kind of Growth Rates

It probably seems obvious that if you want to find great companies in which to invest, you'll want to look for strong growth rates. After all, no company is likely to see its stock advance at a much faster clip than its overall growth rate -- at least, not for long. Still, don't go overboard; unusually high growth rates could be leading you into a trap.

John Neff, the respected manager emeritus of the Windsor Fund, racked up market-clobbering average annual gains of 13.7% between 1964 and 1995. But while he wanted strong earnings-per-share (EPS) growth from his stocks, he was wary of too-strong growth, reportedly favoring growth rates between 7% and 20%.

Whoa, Nelly!
At first, you might think you'd prefer to pick the fastest growers possible. Witness these companies' recent rapid growth:

Data: Motley Fool CAPS.

Unfortunately, such eye-popping growth rates don't tend to last too long. Dig a little deeper into Chinese search-engine specialist Baidu.com, for example, and you'll see that its five-year average EPS growth rate neared 160% -- meaning that its rate of growth has actually slowed considerably in recent years. Research In Motion is an exception, though; its three-year average revenue growth remains a little higher than its five-year average.

It's also instructive to compare EPS growth rates with revenue growth rates, which is why I included revenue numbers above. If EPS is growing faster than revenue, as it is with eBay and Netflix, the company may be cutting costs. However, it won't be able to keep cutting them to grow EPS forever. Ultimately, a company's bottom-line growth rate is limited by its top-line growth rate.

Finally, when a company grows rapidly, people tend to notice. If it's a promising business, the stock doesn't remain unloved for long. It's common for fast growers to trade with steep P/E ratios -- Netflix and Baidu.com, for instance, recently had P/Es of 50 and 95, respectively. At those prices, investors are counting on rapid growth in coming years. If the growth slows, as it likely will, lower stock prices will inevitably follow.

Down to Earth
It can be safer to hunt for stocks that sport strong but still reasonable growth rates, along with low or reasonable valuations. I screened for P/E ratios below 20, and three-year average annual EPS growth rates between 7% and 20%. Here are some of the candidates that popped up:

Data: Motley Fool CAPS.

Such companies deserve a closer look than more torrid highfliers, in my opinion. Even though IBM hasn't seen revenue keep up with profits, it's aiming to expand its software business, which could lead to higher margins and greater earnings. Corning similarly stands to do well with its LCD screens for TVs and portable devices.

Wal-Mart may not grow as briskly as the others can, given its size. But despite its bulk, the Bentonville behemoth has doubled its revenue over the past decade to more than $400 billion, and it's still finding new places to expand.

You don't have to rule out really fast growers entirely -- just be careful with them. To get both solid growth and peace of mind, look for promising companies with more sustainable growth rates.