Growth Stocks
Refers to company shares that have a much higher growth rate than the average rate depicted in the market.
What Is A Growth Stock?
Growth stocks can be defined as company shares that have a much higher growth rate than the average rate depicted in the market.
This suggests that a growth stock will generate more revenue quickly than a regular stock due to its faster growth rate.
The fast growth rate usually results from the company having a unique or more technically advanced product than its competitors.
When this is the case, the consumer base will favor the company’s product, further pushing the stock’s value upwards and ensuring long-term growth.
Due to the high expected earnings of a growth stock, it is worth noting that these stocks have a considerably high price-earnings ratio (P/E).
A P/E ratio is calculated by dividing a company’s share price by the earnings generated per share. This ratio helps investors evaluate whether a company is overvalued or undervalued, thus helping them decide whether to invest in it.
Consumers who recognize a company’s full potential and anticipate it to develop at exponential rates tend to value it highly, as evidenced by a high P/E ratio.
On the one hand, an investor will think long and hard before deciding to pay a current hefty price for a growth stock (due to its high P/E ratio).
On the other hand, that stock might keep growing, as suggested by its name. Therefore, the stock price will also continue growing, encouraging investors to buy the stock early to benefit from future returns.
Key Takeaways
- Growth shares can be defined as company shares with a much higher growth rate than the average rate depicted in the market.
- The price-to-earnings ratio for these stocks is high.
- Due to the company's great potential to generate rising profits and returns, growth investors first pay a high price per share but see higher returns later.
- Companies with growth shares have some type of competitive advantage over other companies in that same industry.
- Growth investments pay little to no dividends.
- Value share is an alternative to growth share.
- Growth shares are riskier than value shares but can yield higher returns in the long run.
Growth Stocks Main Characteristics
Most of these stocks share the same characteristics.
Below are some examples:
1. They do not pay dividends.
These stocks usually do not pay dividends. This is because companies that issue them typically wish to reinvest any money they make to boost earnings shortly.
They wish to do so because these companies experiencing growth are expanding quickly and therefore want to reinvest their earnings into the business, as this will result in a bigger potential when generating earnings.
This means investors will only make money on their investment after selling the shares.
2. High P/E ratio
They have a considerably high P/E ratio, which makes the stocks expensive.
Investors are willing to spend more to purchase the company’s stock because they have high hopes for its future value, increasing their willingness to spend a large amount to own it.
3. Long-term revenue
As mentioned above, these shares tend not to pay dividends, meaning it is hard for investors to make any earnings in the short run. In contrast, this is not the case in the long run.
In the long run, almost the opposite happens. This is because capital appreciation provides investors with significant income over the years. This results from the company experiencing exponential growth in the long run.
Knowing that these stocks have a much higher growth rate than the average rate depicted in the market, we can infer that companies who own these stocks have some competitive advantage over other companies in that same industry.
This competitive advantage results in the company having a Unique Selling Proposition (USP), which other companies in the same industry do not possess.
NOTE
A USP is a statement a company embodies to set its products and brand apart from its rivals. This ultimately is what leads to more interest from shareholders in addition to more company success.
5. High-risk factor
There is no question that these stocks can be very rewarding in the long run, but that is not necessarily the case in the short run. There is some uncertainty in the short run, leading to a significant risk factor.
This is because they rarely pay any dividends, and as mentioned above, investors will only be able to make money on their investments when selling their shares in the long run.
Of course, it is not always the case that a company meets its future expectations and predictions, as some tend to underperform. This is why we say there is a high-risk factor involved.
Why Growth Stocks?
Why should I invest in them? There are mainly two reasons for doing so:
1. High return on investment (ROI)
Growth companies have a much higher growth rate than the average rate in the industry. This could be because they have a competitive edge over others regarding product quality or popularity.
If you invest in good growth stocks, capital appreciation will provide you, the investor, with significant income over the years.
Good growth stocks will likely always succeed due to their constant increase in revenue and growth. As an investor, you can almost guarantee future high returns.
This, as mentioned above, results from the company experiencing exponential growth in the long run.
2. Returns beat the inflation rate.
By investing in these stocks, you can help your money overcome inflation. The returns you receive from investing in them tend to be larger than the economy’s inflation rate.
This means the growth of your money should be substantial and above the inflation rate, barring any market setbacks. Since we are overcoming inflation, this effectively improves your standard of living due to the increase in your real income.
Growth Stock Examples
Below are some of the most well-known growth stocks globally:
1. Amazon.com Inc.
Amazon is considered one of the world's biggest companies. In 2023, it has a P/E ratio of about 55, which is well above average. Usually, the market average ranges from 20 to 25.
NOTE
Investors continue to invest in Amazon even with the high P/E ratio, and this is because people have high expectations for this company's future.
Investors think about the future and long-term regarding Amazon's stocks. Right now, it might seem like a hefty cost given the high P/E, but down the line, as the company is expected to grow, the stock price will level up.
2. Visa Inc.
Visa, a leading global provider of credit cards, owns the world's largest electronic payment network.
In general, Visa earnings and cash flow always have high growth expectations, which motivates investors to take a risk and invest long-term. They have a P/E ratio of about 33, which is considered a high ratio.
3. Apple Inc.
Apple regularly reports high revenue increases, as it has been one of the most popular growth stock investment choices for investors.
They continuously produce innovative products and have a loyal consumer base, giving them a competitive edge over other companies in the same industry. This encourages investors to invest due to the expectation that the company will keep growing.
Apple has a P/E ratio of about 24, which is not considered too high or too low.
NOTE
Apple is no longer viewed as the high-growth stock it was once, but its revenue increase and its loyal consumer base make up for that.
4. Netflix
Netflix's revenue is expected to continue increasing over the years. New company rules as of 2023 will lead to more paid platform members, meaning there is no question Netflix will continue growing its earnings over the years.
The P/E ratio of Netflix is about 36. This is well above average and signifies the willingness of investors to invest in Netflix stocks due to the high expected future returns.
Much like Apple, Netflix has a very strong consumer base on a global level. It is considered a top streaming website for all types of shows. That, along with its competitive edge over similar companies in the same industry, makes it an attractive investment for investors.
Are Growth Stocks Risky?
Yes, they can be very risky. Investors have a disadvantage when investing in these stocks, mainly due to the lack of dividends.
As mentioned above, growth stock investments can be very profitable in the long run, but this does not necessarily apply in the short run. They usually pay no dividends, which means that investors will only benefit from their investment sometime in the future.
But this, unfortunately, assumes one thing, and that is the fact the company will continue to perform great. As we know, this is not always the case, as a company can experience a downfall due to changes in market conditions.
In reality, an investor is investing in something with a certain expectation, but this expectation might not be met later.
For example, the stock price of that growth company might decrease in the long run, thus making the investor's stock valueless. This can lead to the investor incurring losses.
What is an alternative to these stocks? Value stocks are widely considered the perfect alternative.
The fundamental idea of purchasing and selling stocks is the foundation of value stock investing. You can purchase a product at a lower cost and resell it for more money if you know what its true market value is.
This is identical to how to value stock investing functions. To generate significant returns, the investor chooses the stock with the best value, buys it at a discount, and holds it until it reaches its true value.
Growth Vs. Value Stock
Growth shares and value shares are almost opposite.
These are the differences between the two:
| Growth Stocks | Value Stocks |
|---|---|
| Pays little or zero dividends. | Pays high dividends. |
| Generally, has a high P/E ratio. | Generally, has a low P/E ratio. |
| Involves the process of investing in shares expected to grow above the market average. | Involves the process of investing in a company that currently is under the radar but could have strong potential. |
| Very volatile, heavily influenced by market changes. | Not volatile, barely influenced by market changes. |
| A better option is if you are willing to take a big risk and win due to the high P/E ratio. | Safer option if an investor is not a risk taker due to a low P/E ratio. |
The main distinction between growth and value investment is that growth company stocks are what investors believe will provide them returns that are higher than average. In contrast, value company stocks are what investors think the market has undervalued.
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