What are growth stocks?
Growth stocks are stocks of companies that are expected to grow at a rate that is significantly above the average growth for the market. Generally, these types of stocks don’t pay dividends because the growth stock companies usually prefer to reinvest the earnings they have gathered to accelerate growth in the short term.
Issuers of growth stocks are those companies whose net profits or earnings are expected to grow at a faster pace than the market. This means that their stocks have the potential of rising faster than the market. Oftentimes, growth stocks have a high price to earnings (P/E) ratio which indicates that they are overvalued. These stocks are overpriced in the market because stock investors have put into consideration, the high growth rate that is expected of the company.
Hence, the investors that invest in growth stock companies anticipate that they will earn money from eventually selling their shares in the future to make capital gains. People with this type of investment style believe that the fast growth in profits of the company will cause the shares of the company to be more attractive in the future, thus, having a higher price.
Growth stocks are usually from relatively new companies in the new business sectors that show potential for substantial and rapid growth. Because these companies are in an expansive phase, they usually don’t pay dividends. They rather reinvest their earnings in the growth of the company. These companies may appear in any industry or sector that typically trades at a high price-to-earnings (P/E) ratio. They may not seem to have earnings at the time but are expected to in the future. This is why many small-cap stocks (shares of smaller companies) are considered growth stocks. Nevertheless, some larger companies may also be considered growth stock companies.
Investing in growth stocks
Investing in growth stocks is a style of investment with a strategy that is centered on increasing an investor’s capital. Growth investing entails investing in growth stock companies which include young or small companies whose earnings are expected to increase at an above-average rate than the overall market or compared to other companies in the same business sector.
Growth investing is very attractive to several investors because purchasing stocks in emerging companies can render impressive returns once the companies are successful. However, investing in growth stocks can be risky because such companies are untried. More so, the company doesn’t offer dividends and the only opportunity to earn money from growth investing is when investors sell the shares.
Hence, in an instance where the company doesn’t do well, the investors take a loss on the stock when he chooses to sell. Value investing can be contrasted with growth investing. This type of investment style involves buying value stocks. These are stocks that seem to be trading less than their intrinsic or book value.
Characteristics of growth stocks
- Promising growth industry
- Strong leadership team
- Commanding market share
- Strong growth in sales
- Large target market
- Innovative (unique product or service)
- Expansion of profit margin
- Manageable debt level
Investors, while researching for growth stocks, may discover that these stocks are not all equal. However, the stocks that are considered to be growth stocks tend to share many of the same characteristics. When looking for growth stock investments, the key things to be put into consideration are the company’s leadership team, innovative ideas, industry growth prospects, strong sales growth, and market share. These characteristics of growth stocks can signal a company that may be poised to take off.
How to identify growth stocks (characteristics)
Growth stocks can be found trading on any exchange and in any industrial sector. However, they are usually found in the fastest-growing industries and on more innovative exchanges such as the Nasdaq. When it comes to stocks, growth indicates that the company has substantial room for capital appreciation. Hence, growth stocks are usually newer and smaller-cap companies. They are also companies in growth sectors such as technology, biotech, etc. Such companies may even have low or negative earnings with high P/E stocks. Discussed below are how to identify growth stocks and the characteristics of growth stocks to look out for:
Promising growth industry
When looking out to invest in growth stocks, find companies in a promising growth industry. Companies with intention of growing should be in industries where huge growth is possible and probably already in evidence. Hence, growth stock companies are not usually found in industries that are at the tail end of their growth trajectories.
For instance, investing in a mobile app start-up may be more ideal than investing in a personal computer (PC) hardware vendor. This is because the software industry tends to be growing at the moment with more prospects for growth.
Strong leadership team
It is evident that growth stock companies tend to have a strong leadership team that is focused on increasing the sales and profit of the company. The foresight and capabilities of the management and executive team matter especially for future growth. Without an innovative group of leaders, growth may not happen in the company.
A lot of companies don’t grow in business because of bad business leadership skills. Once, the management team has a strong background in the industry that the business is participating in, there is room for fast growth. This is because they have come across some of the problems they are attempting to solve as they rendered their professional service in the former businesses. Hence, they have become increasingly familiar with the industry’s practices and issues.
It is important that when seeking growth investment, investors should look out for companies that have executives and managers with a good track of success, innovative thinking, and noteworthy visions for where they aim for the company to reach. Since growth companies can be young and may not have a significant performance history for investors to count on, they can examine the records of leaders of the company before they joined the prospective company.
This means that the leadership of a company tells a lot about its prospect for growth. Good and great leaders are known to post short-lived successes. Hence, if you’re looking out for growth investments in a company, it is advisable to research the leadership teams. However, companies with executives and managers with a good track of success may not be a 100 percent guarantee that investing in that company is a good investment, but it can help weed out potential risks.
Commanding market share
The market share of a company is its total sales relative to the total sales of its industry. This shows how competitive the company is compared to others in the same industry. Hence, when growth investing, investors should look out for companies with a commanding market share.
In an emerging growth market, companies with prospects for growth would have a growing market share which also means growing revenue. Growth stock companies continue to go after new avenues for success and have the free cash flow to invest in innovative products and services.
Strong growth in sales
The company’s sales are also a prime consideration when looking for a growth stock investment. How to identify growth stocks in the market is to look out for companies that are undergoing acceleration in the growth of their sales, revenue, and earnings over consecutive quarters.
Investors, mark out increasing sales growth relative to market breakthroughs or a new management team’s tenure. Companies with irregular or slowing growth are not good picks for growth investment. The faster the growth rate of a company, the greater the probability of the company’s stock price increasing. This is because when a company has boosted sales and earnings, it becomes an attractive investment.
Growth stock companies have a way of disrupting the market by introducing new products or new processes, or by just tapping a previously unserved segment of the market (market niche). This is why the sales of top-growth stocks seem to grow at a faster rate than their peers in the industry.
Notwithstanding, one has to be very diligent when assessing the sales growth of a company. For example, many high-growth stocks see triple-digit growth rates when the company is young. However, sales can slow down as the company and industry mature. Hence, demand for the stock may decrease.
With growth investing, future growth is more important than past growth. Hence, the best growth stocks to buy now are those that still have significant potential ahead. Potentials that are based on a largely unserved total addressable market (TAM) and a relatively low market share that is progressively expanding.
Large target market
Growth investors look out for companies with a large target market. Growth stock companies don’t get rich by just selling a niche product to a handful of customers. For growth in business, the company needs to be selling to a large target audience of customers.
How to identify growth stocks is to look out for companies that are serving huge markets. The opportunity for sales and revenue is greater when there is a bigger pool of potential customers. This is what drives growth. Take Apple and the iPhone as an example- without Apple’s massive market, the iPhone may not have seen so much sustained success. Therefore, growth stocks usually have a large target market that gives them the potential to grow.
Innovative (Unique product or service)
How to identify growth stocks is to mark out companies that are making revolutionary changes and bringing up innovative ideas. One of the most important characteristics of growth stocks is that they are innovative. They sell solutions to problems that are considered relevant to their target market.
Look at Google for instance, before it existed, finding stuff on the internet was a hassle. One would usually come across irrelevant and unwanted content in the process of searching the internet. Google, as a search engine, solved that problem by proffering a solution called SEO that we all use today. It renders a single-field search that optimizes search results based on their relevance to what was searched.
One of the traits that growth stock companies have in common is that they have unique products. These companies may have access to technologies or hold patents that put them ahead of others in their industry. They can even reinvest profits to develop newer technologies and patents to ensure longer-term growth, thus, staying ahead of their competitors.
Because they tend to be innovative, these companies have a loyal customer base and a significant amount of market share in the industry. A company that is the first to provide a new service or launch a new product may become a growth stock by gaining market share for being the only company to provide a new service. Now, if other companies venture into the market with their own version of the new service, the company that is able to attract and keep the largest number of customers for the new service has the greater potential of becoming a growth stock.
Expansion in profit margin
The best growth stocks manage to expand their profit margin progressively on a yearly basis and usually display an elevated gross profit margin. However, during the early stages, the growth margins of these stocks can be narrow.
The indication of a high gross profit margin is that once significant business volumes are attained, the company will be very capable to translate its higher sales into elevated bottom-line profits. After all, steadily expanding profit margins will contribute to the company increasing trading multiples over time. Hence, yielding a higher market capitalization.
Manageable debt levels
How to identify growth stocks is to look out for companies with manageable debt levels. This is because companies that have too much debt may face trouble in the future. Hence, it is crucial to identify how much debt the company has in relation to how quickly it is growing its sales. When there is too much debt, growth tends to be very slow.
Growing companies will need capital to continue expanding. So, it’s understandable that they will have to raise money constantly to keep building their core business with further investment. However, it is usually not a good idea for these growing companies to raise these funds through debts unless the debt produces no interest or low-interest expenses.
For example, publicly traded growth companies, in most cases, issue convertible debt notes. These debt instruments, in the future, can be exchanged by the holders of a certain number of common shares and in exchange, lenders usually request a lower interest rate than what traditional bonds offer.
How to value growth stocks
When investing in growth stocks, some investors could think that past performance is a crucial factor. However, positive past performance does not always necessarily actualize future growth. This is because the majority of the potential of growth stocks will be realized in the future. So, when trying to estimate the fair value of the growth stock, past-looking metrics will not be as relevant as forward-looking metrics. This means, how to value growth stocks would not demand reliance on the traditional price-to-book ratio (P/B), price-to-earnings (P/E) ratio, and EV/EBITDA metrics. Some alternative valuation methods have to be used when assessing growth companies.
Estimating how much of the total addressable market (TAM) of the company, that the company can effectively tap into within the next 5 years is one of the valuation metrics to use to value growth stocks. This makes it easier to estimate how much the business can produce in terms of revenue by then. Now, supposing the current market price of the stock is still relatively conservative compared to the growth potential of the company in the next 5-10 years. This means that the stock would be seen as attractive to an investor that wants to buy and hold it.
Therefore, even though past performance can be a good indication that a business has done well, in growth investing, the future prospects of the business are more important. See it as you investing in what develops next, and not in what has happened in the past. The following few elements matter more than the past performance of growth stock companies:
- New markets that the company can still tap into
- A relatively large and unserved total addressable market (TAM)
- Developed new products and services with intention of being launched soon
- Innovating new processes that have the potential to increase profit margins over time
Types of growth stocks
- Constant growth stock: The earnings and dividends of this type of growth stock are assumed to increase at a stable rate in perpetuity.
- Nonconstant growth stock: The growth rate of this type of stock is either faster or slower than the economy as a whole during the portion of the firm’s life cycle. The dividends are not likely to grow at a constant rate. This can also be called supernormal growth stock.
- Secular growth stock: These are stocks of companies in a period of fundamental change in a sector or industry, leading to significant and persistent growth.
- Aggressive growth stocks: These type of investment seeks to return the highest capital gains.
- Supernormal growth stock: This type of stock experiences robust growth for a time and then eventually reverts back to normal levels of growth.
- Large-cap growth stocks: These are stocks of companies with a large market capitalization that is expected to grow at a rate that is significantly above the average growth for the market
- Mid-cap growth stocks: These are stocks of medium-sized companies that are expected to grow at a rate that is significantly above the average growth of other mid-cap stocks.
- Small-cap growth stocks: These are stocks of small companies that are expected to grow at a rate that is significantly above the average growth of other small-cap stocks.
Examples of growth stocks
- T-Mobile US Inc. (TMUS)
- Vertex Pharmaceuticals Inc. (VRTX)
- Alphabet Inc. (GOOG, GOOGL)
- Halliburton Co. (HAL)
- Meta Platforms Inc. (Facebook)
- TransDigm Group Inc. (TDG)
- Starbucks Corp. (SBUX)
- Amazon.com, Inc. (AMZN)
According to an article, ‘The Best Growth Stocks Of 2022’ on www.forbes.com, Bank of America recently updated the examples of growth stocks listed above as its ‘Growth 10’ best growth stocks list. The Bank of America analysts believe these growth stocks offer the most upside.
It is important to note that the growth stocks listed above are sourced from industry analysts and may be among the best growth stock to buy now. However, these stocks may not fit perfectly into every growth investor’s portfolio. Hence, before any investor decides to purchase any of these stocks, they should do enough research to be sure they align with their financial goals and risk tolerance.
Here is a table showing the examples of growth stocks listed and some of their fundamentals as stated in the article ‘The Best Growth Stocks Of 2022‘ as of May 24, 2022.
|Examples of growth stocks||3-Year Annualized EPS (Earnings per share)||3-Year Annualized Revenue||Return on Equity|
|1||T-Mobile US Inc. (TMUS)||-10.4%||+22.7%||4.1%|
|2||Vertex Pharmaceuticals Inc. (VRTX)||+3.7%||+35.5%||24.7%|
|3||Alphabet Inc. (GOOG, GOOGL)||+37%||+23.5%||30.8%|
|4||Halliburton Co. (HAL)||-4.8%||+13.9%||25.4%|
|5||Meta Platforms Inc. (Facebook)||+22%||+28.3%||29.1%|
|6||TransDigm Group Inc. (TDG)||-13.7%||+7.9%||N/A|
|7||Starbucks Corp. (SBUX)||+3%||+5.5%||N/A|
|8||Amazon.com, Inc. (AMZN)||+47.6%||+26.4%||18%|
Amazon, as one of the growth stocks examples
For a long time now, Amazon Inc. (AMZN) has been considered a typical example of a growth stock. It has been one of the largest companies for some time now. In terms of market capitalization, Amazon ranked 4th as of Sept 24, 2021. The stock of Amazon has historically traded at a high P/E ratio which ranged from about 58-106 between June 2020 and September 2021.
FAQs on growth stocks
What is growth stock definition?
Growth stocks are stocks of companies that are expected to grow at a rate that is significantly above the average growth for the market.
Do dividend stocks outperform growth stocks?
Dividend stock companies are more mature and steady businesses than growth stock companies. As a result, the overall risk profile for dividend stocks is much lower compared to growth stocks because the business is less likely to go bankrupt.
Dividend stocks return capital to investors in form of dividends or stock buybacks because the business is making very healthy profits and has reached the pinnacle of its growth. Hence, they are ideal for investors that are looking for a more immediate return and steady cash flow or for investors nearing retirement because it serves as a source of passive income.
However, investors that are looking to create wealth or investors that are still far away from retirement, would find growth stocks attractive because in their own case, it offers significantly higher upside than dividend stocks. Growth stocks don’t pay dividends because instead of returning cash flows to investors, they reinvest aggressively into their businesses to grow their products and services or enter new markets. Therefore, whether dividend stocks outperform growth stocks or not will depend on the investor’s financial goal and investment style of preference.
Is coca cola a growth or an income stock?
Coca-cola is one example of a strong dividend-paying business. Hence, it is no doubt an income stock being that it pays dividends and is a mature steady business. The Coca-cola company usually pays dividends four times a year- April 1, July 1, October 1, and December 15.
Is MSFT stock an income stock or a growth stock?
Microsoft (MSFT) stock can be considered an income stock being that the company pays its shareholders dividends. A quarterly dividend of $0.62 per share is paid by Microsoft to shareholders.
What type of company do growth stocks come from?
The type of companies that issue out growth stocks is usually newer and smaller-cap companies. Growth stocks can also come from companies in growth sectors such as technology, biotech, etc.
- Gross Profit vs EBIT: Differences and Similarities - November 28, 2022
- Asset Turnover Ratio Formula and Calculations - November 27, 2022
- Statement of Retained Earnings GAAP vs IFRS: Differences and Similarities - November 24, 2022