All stock prices do not move at the same rate. Some stocks shoot up very quickly while others move at a leisurely pace. This difference in the growth potential is what distinguishes a growth stock from a value stock. However, the distinction between growth and value stocks is not always very clear even in developed markets. In India, the difference is even less defined.
Investors in such stocks believe that the fast growth in profits will make the shares more attractive in the future and fetch a higher price. These stocks are often from relatively new companies in sunrise industries. These companies usually don’t pay dividends. Since they are in an expansive phase, they prefer to reinvest their earnings to make the business grow.
Table Of Content
- What Are Growth stocks?
- Understanding The Concept of Growth Stock
- How to Find Growth Stocks?
- Example of Growth Stock
What is a growth stock?
A growth stock is the stock of a company that's expected to increase its profits or revenues faster than the average business in its industry or the market broadly. Growth stocks appeal to many investors because Wall Street often values a company based on a multiple of its earnings (its profits), which may be diminished if the company is reinvesting most of its leftover cash in further expansion.
Growth-oriented companies tend to have savvy leadership teams focused on innovation, along with sizable market opportunities. They're often on the forefront of macro trends such as the rise of e-commerce and advances in financial technology. Amazon (NASDAQ:AMZN), for example, was a pioneer in the e-commerce space when it started selling books online in 1995. Alphabet (NASDAQ:GOOG) revolutionized digital advertising. And, more recently, Square (NYSE:SQ) brought digital payment services to small businesses.
Understanding Growth Stocks
Growth stocks may appear in any sector or industry and typically trade at a high price-to-earnings (P/E) ratio. They may not have earnings at the present moment but are expected to in the future.
Investment in growth stocks can be risky. Because they typically do not offer dividends, the only opportunity an investor has to earn money on their investment is when they eventually sell their shares. If the company does not do well, investors take a loss on the stock when it's time to sell.
Growth stocks tend to share a few common traits. For example, growth companies tend to have unique product lines. They may hold patents or have access to technologies that put them ahead of others in their industry. In order to stay ahead of competitors, they reinvest profits to develop even newer technologies and patents as a way to ensure longer-term growth.
Because of their patterns of innovation, they often have a loyal customer base or a significant amount of market share in their industry. For example, a company that develops computer applications and is the first to provide a new service may become a growth stock by way of gaining market share for being the only company providing a new service. If other app companies enter the market with their own versions of the service, the company that manages to attract and hold the largest number of users has a greater potential for becoming a growth stock.
Many small-cap stocks are considered growth stocks. However, some larger companies may also be growth companies
How to Find a growth stocks
Growth stocks also share some quantitative characteristics, including:
- Rising profit margins: The best growth stocks are those of companies with profit margins that are increasing over time. Profit margins that are negative but become positive while an investor holds the stock can result in significant share price increases, generating very high returns for the investor's portfolio. Other rapidly growing companies are already profitable and still increasing their profit margins; these companies are lower-risk investments and are usually more suitable for new growth stock investors.
- High returns on equity: ROE, or return on equity, is equal to net income as a percentage of shareholders' equity. A company with a high or rising ROE relative to its competitors uses capital more efficiently to generate profits.
- Strong sales growth: The best growth-oriented companies also significantly increase their revenues over time since the only reliable way to grow profits for years on end is to grow revenues, too.
- Projected growth of earnings: Analysts projecting that a company's earnings are likely to grow is a positive sign, and though analysts' projections aren't always accurate, they are useful for gauging market expectations
- Manageable levels of debt: Since it's possible to achieve a high ROE by assuming high amounts of debt, it's important to also evaluate a company's liabilities. The company's ROE should not be overly influenced by its debt, and its debt levels should be comparable to those of competitors. The company's historic performance should show a trend of the company keeping its liabilities at manageable levels.
Example of a Growth Stock
- Amazon Inc. (AMZN) has long been considered a growth stock. In 2021, it is one of the largest companies in the world and has been for some time. As of Sept. 24, 2021, Amazon ranks fourth among U.S. stocks in terms of its market capitalization.
- Amazon's stock has historically traded at a high price-to-earnings (P/E) ratio. Between June 2020 and September 2021, the stock's P/E has ranged from around 58 to 106.3 Despite the company's size, earnings per share (EPS) growth estimates for 2022 is over 67.4
- When a company is expected to grow, investors remain willing to invest (even at a high P/E ratio). This is because several years down the road the current stock price may look cheap in hindsight. The risk is that growth doesn't continue as expected. Investors have paid a high price expecting one thing, and not getting it. In such cases, a growth stock's price can fall dramatically.
How Do You Know If a Stock Is Growth or Value?
Instead of looking to future growth potential, value stocks are those that are thought to trade below what they are really worth and will thus theoretically provide a superior return as their stock prices catch up with fundamentals. Unlike growth stocks, which typically do not pay dividends, value stocks often have higher than average dividend yields. Value stocks also tend to have strong fundamentals with comparably low price-to-book (P/B) ratios and low P/E values the opposite of growth stocks.