Investors have several strategies that they can use to make money in the stock market. One popular strategy is to buy shares of growth stocks, which are businesses that are expanding their profits (or revenues) at a faster-than-average pace. Companies that can do so for an extended period of time tend to be rewarded with a higher share price, enabling their investors to make earn big returns through capital appreciation.

But how do investors find growth stocks to invest in? Here are a few methods I use to identify companies that are about to take off.

Coins and a rolled $10 bill are stacked to look like rocket ship with its shadow on the wall behind it.

Image source: Getty Images.

What is a growth stock?

A growth stock is a company that is expected to increase its profits (or revenue) at a much faster rate than the average business in its industry or the market in general. Growth stocks appeal to many investors because Wall Street often values a company based on a multiple of its earnings. Generally speaking, the faster that a company can grow its profits, the faster its share price should appreciate. 

Where to look for growth stocks

If you look at the list of the best-performing stocks of the last decade you'll notice that many of these companies didn't exist a few decades ago but have since become household names. Amazon.com (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), and Ulta Beauty (NASDAQ:ULTA) all started out as tiny players in their respective markets but steadily convinced consumers to buy from them instead of the competition. That helped drive huge revenue and profit growth over the years and turned these companies into winning investments.

So how can you identify the next Amazon.com, Netflix, or Ulta Beauty while it is still in its infancy? One method is to comb through your recent habits to see if you can identify products or services that you are regularly buying from today that you hadn't in the past. If you (or your friends) have fallen in love with a new product or service, then there's a decent chance that the company behind that product is worth investigating.

I've personally made several profitable investments over the last decade by simply observing my own buying habits. Here are a few recent examples:

  • My family rarely eats out, but when we do we like to buy from healthier quick-service restaurants, such as Chipotle (NYSE:CMG) or Panera Bread, instead of full-service restaurants or traditional fast food places Wendy's or McDonald's.
  • My wife and I have eliminated soda from our lives. The only beverages that I drink now are water and Starbucks (NASDAQ:SBUX) coffee. My wife prefers to drink sparkling water like National Beverages' (NASDAQ:FIZZ) La Croix brand. 
  • We mostly buy organic food and we love to shop at stores like Whole Foods (now owned by Amazon.com) and Trader Joes.
  • We ditched cable a few years ago and now all of our entertainment needs are met by streaming services that are offered by Amazon.com, Netflix, and Alphabet's YouTube.
  • Most of our household items and gifts that are purchased online at Amazon.com or Wayfair

I'd bet that if you reviewed your credit card statements, you'd quickly recognize a few patterns as well. Ask yourself: Are there any retails stores or restaurant concepts that you frequent now but didn't before? Are there any new foods or drinks that you now buy from the grocery store? Have you become a raving fan of a particular website or app?

A quick internet search can help you find the companies that are behind the products or services that you've grown to love. If they are publicly traded companies and still in the early stages of their growth cycles, then you may have stumbled upon a potential winner.

Keep an eye out for macro societal trends

The best growth stocks tend to benefit from a massive change that happens in society. Companies that are able to capitalize on a trend that takes years to play out can often see their revenue and profits grow for years on end and can generate huge returns for investors.

So what macro trends are happening right now that investors can take advantage of? Here are a few that I'm following with great interest:

  • Health and wellness: Have you noticed that more Americans are starting to adopt a healthier lifestyle? This trend is unfolding in numerous ways, such as the growing popularity of yoga to the rising use of organic foods. This is a trend that looks like it is here to stay and is poised to benefit many different companies. From organic foods distributors, like United Natural Foods, to yoga clothing makers, like lululemon athletica, there are many ways that investors can take advantage of this trend.
  • The war on cash: I've grown accustomed to using debit and credit cards to pay for everything, so I was shocked to learn that 85% of global transactions still take place using cash or check. Given the benefits that come from going cashless -- faster transactions, never having to deal with change, the ability to earn rewards -- I'm a big believer that many consumers will switch to plastic over time. That's a big reason why my personal portfolio is full of companies that will benefit from this shift like Visa, Mastercard, and Square.
  • The rise of online advertising: Do you like getting cold calls? Receiving junk mail? Watching television commercial? Me neither. That's why consumers are using caller ID, DVR, and put their names on do not call lists to limit their exposure to these daily interruptions. However, these realities are making it harder and harder for big companies to get their message out to new customers. That's why more of them are shifting their ad dollars toward online channels so they can still keep in touch with their consumers. This spending shift is creating a huge opportunity for companies that excel at reaching consumers online such as Hubspot (NYSE:HUBS)The Trade Desk (NASDAQ:TTD), and Facebook (NASDAQ:FB).
  • The graying of the U.S. population: Did you know that 10,000 Americans will turn 65 every single day between 2010 and 2029? This massive demographic shift is a strong tailwind for all companies that cater to the needs of seniors. All kinds of businesses will benefit from this trend including assisted living property owners, like Welltower, and healthcare conglomerates, like Johnson & Johnson.

This is a just a few of the macro shifts that are taking place in our society today. The next time you notice one happening, do a little research to see if there are any companies that will benefit from the trend.

Piggyback on the legends

Wall Street fund managers usually have huge research budgets at their disposal that they use to find great businesses. Since these big money managers are required to report their holdings to the SEC every 90 days, it can be an eye-opening learning experience to pick through their recent buys and sells to see what stocks they like.

While not every growth fund manager is worth following there are several that I greatly respect and can be a wonderful source of stock ideas. Here are a few of my favorite growth investors to follow:

  • Pat Dorsey of Dorsey Asset Management: Dorsey was the director of equity research at Morningstar for more than a decade an authored two must-read books for growth investors: The Five Rules for Successful Stock Investing and The Little Book that Builds Wealth. Dorsey now runs his own asset management business and he makes concentrated bets in growth stocks that he believes will be able to compound shareholder wealth for years.
  • Chuck Akre of Akre Capital Management: Akre ran the FBR Focus Fund from 1997 to 2009 and produced annualized returns of more than 12% during his tenure, which was far ahead of the 4.4% return of the S&P 500 over the same time frame. Akre launched his own mutual funds in 2009. His style is to buy growth stocks that are trading for value prices and he rarely sells. He also runs a concentrated portfolio.
  • Carl Icahn of Icahn Capital Management: Long-term investors in Icahn's publicly traded investment vehicle Icahn Enterprises (NASDAQ:IEP) has enjoyed market-beating returns. Icahn's net worth has ballooned to more than $18 billion because of his knack for finding mispriced stocks. In recent years, he has become an activist investor who buys a meaningful position in a company and then shakes up its Board of Directors and management team in an effort to improve the business. While his fast-paced style isn't for everybody, I always enjoy looking at his portfolio to see what he has been buying or selling recently.

There are also a plethora of websites out there that make easy to track and rank what notable growth investors are doing, including Whale Wisdom, TipRanks, and Guru Focus. Growth investors can visit any of these sites and quickly learn what many big-time money managers have been buying and selling in recent months to come up with stock ideas of their own. 

Stock screening tools

Other reliable sources that I use to find growth ideas are free screening tools. While there are several for investors to choose from, my personal favorite is called Finviz. This easy-to-use website has data on more than 7,300 companies and investors can input a variety of parameters to help them find stocks that fit the criteria they find most useful.

Here are a few traits that I regularly use to screen the market for growth stocks:

  • Market cap: This metric is a quick way to measure a company's size. Since I abhor penny stocks, I tend to stay away micro-cap companies. A good way to do this is to screen for companies that have a market cap of at least $300 million. Since most penny stocks are worth far less than $300 million, this is an easy way to keep them off your radar.
  • Profitability: Companies that are showing consistent profits tend to be much less risky than those that are burning capital. That's a big reason why I tend to favor growth stocks that have already crossed into the black. A quick way to screen for profitability is to set the P/E ratio to be a positive number. This will weed out any businesses that have not yet produced positive net income.
  • Sales growth: The best growth stocks are capable of growing their profits for years on end and there's no reliable way to do that without increasing revenue, too.
  • Projected profit growth: Wall Street analysts are paid huge sums to follow companies closely and publish reports that predict their growth rates over the next several years. While these projections can be wildly inaccurate, I do find them useful is gauging what the market expects from them. 
  • Sector: Some sectors are harder places for investors to make money than others. I shy away from commodity industries like basic materials and energy and instead focus my time on sectors where businesses can build a lasting competitive advantage. My favorite fishing grounds are the technology, healthcare, services, and financial sectors. However, it's important for investors to stick with industries that they understand, so these sectors might not be great hunting grounds for everybody.
  • Balance sheet: While debt isn't always a bad thing, I don't like to invest in companies that carry huge amounts of debt on their balance sheet. That's why I like to use the debt-to-equity ratio to eliminate highly indebted companies from my search. This ratio compares the amount of total debt that a company has to its shareholder equity, which can be thought of as the net worth of the business. A good rule of thumb is to set the debt-to-equity ratio below 30%. However, the lower this number is, the better. As you'll see in the example below, I tend to be even more conservative when it comes to debt. But keep in mind that some industries naturally use more debt than others, so be careful when comparing this number to companies that are in different industries. 

With these parameters in mind, let's run a stock screen using the following criteria:

  • Market cap over $300 million.
  • Based in the U.S. 
  • Profitable on a trailing (meaning the company's actual results for the last 12 months) and forward (meaning its estimated profits over the next 12 months) basis. 
  • Positive earnings growth over the past five years.
  • Sales growth of at least 10% over the past five years.
  • A debt-to-equity ratio below 0.1.
  • Expected profit growth of 15% or more.

Finviz quickly identified 66 companies that match all of this criteria. Here's a look at the top 10 by market cap:

Company Market cap Industry
Alphabet  $710 billion Internet Information Provider
Facebook $464 billion Internet Information Provider
Applied Materials $52 billion Semiconductor Equipment
Monster Beverage $31 billion Soft drinks
Align Technology $19 billion Medical Devices and Equipment
Arista Network $19 billion Diversified Computer Systems
Ulta Beauty $14 billion Specialty Retail
CoStar Group $14 billion Property Management
Abiomed $14 billion Medical Devices and Equipment
Match Group $12 billion Internet Information Provider

Table source: Finviz. 

While there is no bullet-proof formula for creating a list of great growth stocks, using screening tools like Finviz can be a great way to identify potential winners. It can also be a great way to discover growth companies while they are still small and in the early innings of their growth cycle, which can allow investors to get in on the bottom floor.

For example, I used finviz in the recent past to find a dynamic growth company called HealthEquity (NASDAQ:HQY). I quickly learned that HealthEquity's revenue and earnings have compounded at 38% and 57%, respectively, over the last five years. Those numbers convinced me to dig deeper and I soon became so excited about the company's prospects that I purchased shares for myself right away.

So what does HealthEquity do? The company operates an online platform that is primarily used to manage health savings accounts (HSA). These accounts enable employees with high-deductible healthcare plans to completely avoid paying taxes on their healthcare costs. Since healthcare premiums have been rising fast in recent years, HSAs have become increasingly popular with employees and employers alike who are looking for ways to lower their healthcare spending.

The rising popularity of HSAs have enable HealthEquity's user base to grow by leaps and bounds over the last few years:

Metric Fiscal 2018 Fiscal 2017 Fiscal 2016
HSA accounts 3.40 million 2.75 million 2.14 million
Custodial assets $6.8 billion $5.0 billion $3.7 billion

TABLE SOURCE: HEALTHEQUITY.

The strong growth in HSA accounts and custodial assets have worked wonders for HealthEquity's financial statements because the company monetizes its customers in four primary ways:

  • The company earns subscription fees from health plans and employers who offer their members access to HealthEquity's platform.
  • HealthEquity earns custodial fees based on to the total amount of assets held under management.
  • The company charges interchange fees whenever payments are made through its network.
  • HealthEquity earns recordkeeping and investment advisory services fees.

Put simply, the more HSA accounts and custodial assets that are on HealthEquity's platform, the more revenue it generates.

What excites me most about HealthEquity is that the company has already grown big enough to start generating meaningful profits and cash flow, which helps to lower its risk profile. What's more, HealthEquity's current market share is only about 15%. When combined with the fact that the overall market for HSAs is poised for rapid growth, I think that the odds are very good that this company can continue to increase its profits and revenue at a double-digit rate for years to come.

The risks of investing in growth stocks

While investing in growth stocks can be great, there is a Catch-22 that investors should to be aware of. When Wall Street believes that a company is going to rapidly increase its profits, then it is usually awarded a very high valuation. That fact greatly increases the risk that the company's stock could fall dramatically if it fails to meet investor's expectation. That's one reason why investors need to be very picky about which growth stocks they choose to buy. 

Let's circle back to HealthEquity to demonstrate what I mean. As of the time of this writing HealthEquity is trading for more than 100 times trailing earnings and about 21 times sales. Those numbers are sky-high when compared to the average business in the S&P 500, which raises the risk profile of HealthEquity significantly. If the company fails to deliver on Wall Street's growth targets then shares could fall significantly. 

Another risk that investors need to be mindful of is that growth stocks are usually much more susceptible to wild price swings in turbulent markets than value stocks. The volatility can be unnerving at times, so if you're the type of investor who can't handle big price swings, then growth investing probably isn't for you. 

Is growth investing right for you?

Using these methods will help you identify dozens of stocks that hold lots of growth potential. Of course, finding great growth stocks is one thing. Having the gusto to buy them and then hang on through thick and thin is another. However, if you can learn to do so successfully, then you'll put the power of compound interest on your side and be in a great position to generate meaningful wealth over the long term. 

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Brian Feroldi owns shares of Alphabet (A shares), Alphabet (C shares), Amazon, Chipotle Mexican Grill, Facebook, HubSpot, Mastercard, Netflix, Square, Starbucks, The Trade Desk, Ulta Beauty, and Visa. The Motley Fool owns shares of and recommends Abiomed, Align Technology, Alphabet (A shares), Alphabet (C shares), Amazon, Arista Networks, Chipotle Mexican Grill, Facebook, HubSpot, Johnson & Johnson, Mastercard, Monster Beverage, Netflix, PayPal Holdings, Starbucks, The Trade Desk, Visa, and Wayfair. The Motley Fool owns shares of Square and has the following options: short May 2018 $140 calls on Johnson & Johnson. The Motley Fool recommends CoStar Group, Lululemon Athletica, Ulta Beauty, and Welltower. The Motley Fool has a disclosure policy.