What are “Growth Stocks”?
A growth stock is a share of a company that is expected to significantly outperform the broader market. Usually, it reinvests its profits back into the business rather than distributing them to existing shareholders via dividends. Generally, the investment case for growth companies is capital appreciation as they pay very little or in most cases no income. The funds reinvested are employed to fund future growth and can be new projects (such as R&D into new unique products) that could drive the company’s share price higher in the long-term.
Key Learning Points
- Growth stocks are shares of companies that are expected to deliver reasonably higher growth rate than the market average over the long-term
- They do not distribute company profits, being in the form of dividends or shares, but re-invest the proceeds into new projects to fuel further growth
- Growth stocks usually look expensive relative to the market and trade on higher valuations (e.g. on a price-to-earnings basis) due to future growth prospects being priced in the company’s shares
- They are the opposite of value stocks, which tend to look for companies that currently trade below their intrinsic value, for example as a result of disruption in their earnings streams
- A growth stock can experience a significant fall in its share price if it fails to meet investor expectations for outperformance relative to the market
The Fundamentals of Growth Stocks
Growth stocks are typically associated with the Technology Sector but growth-oriented businesses could appear in any sector of the market. Although growth is supposed to be the objective of companies with smaller market capitalization, there are large-cap companies that offer higher growth prospects too. There are various metrics that could be applied in the search for growth stocks, but they usually exhibit higher valuation metrics such as price-to-earnings or price-to-book ratio (more common for the financials sector), or a low dividend yield.
Growth companies typically offer very little or no income at all to shareholders, as opposed to dividend stocks where their main investment objective is capital appreciation. These businesses tend to offer innovative products, often protected by a patent, which gives them a competitive edge in their market segment. Reinvesting rather than distributing profits to shareholders allows these companies to stay ahead of the market and potentially disrupt new areas by developing and researching new unique products. In addition, these companies tend to have a higher rate of customer retention and enjoy a loyal and growing customer base.
Growth Versus Value Stocks
Growth and Value differ significantly in many ways, and this is visible in their valuations. Future revenue streams often tend to be priced in the value of growth companies, where value stocks are usually trading below their fair price as a result of negative investor sentiment, usually triggered by lower than expected earnings, corporate or operational change. Typically, value companies can offer higher dividends to existing shareholders and have a strong payout track record, which often signals a reliable income stream and could at least compensate investors to some extent for the decline in share price they may have experienced.
Investors should also be aware that growth stocks are usually a higher risk and should potential growth forecasts not materialize, their share price could significantly decline. The combination of uncertainty over the short-term combined with the distribution of no income also adds to the higher risk factor of these companies.