Growth stock

What Is a Growth Stock?

A growth stock represents shares of a company that is anticipated to grow its revenues and earnings at a rate significantly faster than the average company within its industry or the broader market. This focus on rapid expansion positions growth stocks as a key component of a growth investing investment strategy, a broad category within equity investing. Companies issuing growth stocks typically reinvest most of their profits back into the business to fuel further expansion rather than distributing them as dividends to shareholders. The primary objective for investors in growth stocks is capital appreciation, driven by the expectation that the company's expanding operations will lead to a higher share price over time.

History and Origin

The concept of growth investing, and consequently, the focus on the growth stock, gained prominence in the mid-20th century. While rapid growth companies have always existed, the formalization of "growth investing" as a distinct investment strategy is often attributed to pioneering investors like T. Rowe Price Jr. and Philip Fisher. Thomas Rowe Price Jr., sometimes called the "father of growth investing," founded the T. Rowe Price Growth Stock Fund in 1950, which was among the first mutual funds explicitly designed to invest in companies with above-average growth prospects.⁶,, Later, Philip Fisher's influential 1958 book, "Common Stocks and Uncommon Profits," further articulated the philosophy behind identifying and investing in companies poised for significant long-term growth. These early proponents emphasized in-depth qualitative and quantitative fundamental analysis to uncover businesses with sustainable competitive advantages and the potential to continually expand their operations and market share.

Key Takeaways

• A growth stock belongs to a company expected to achieve above-average increases in revenue and earnings per share.
• Growth companies typically reinvest profits back into the business to fund expansion, often paying little to no dividends.
• Investing in growth stocks primarily targets capital appreciation, with investors anticipating higher stock prices in the future.
• Growth stocks can exhibit higher volatility compared to other types of equities due to their reliance on future expectations.
• Identification often involves analyzing factors like high return on equity, strong market position, and innovative products or services.

Formula and Calculation

While there isn't a single universal formula to "calculate" a growth stock, investors often look at specific metrics to assess a company's growth potential. Two commonly used metrics are earnings per share (EPS) growth rate and revenue growth rate.

Earnings Per Share (EPS) Growth Rate:
$\text{EPS Growth Rate} = \left( \frac{\text{Current Period EPS} - \text{Prior Period EPS}}{\text{Prior Period EPS}} \right) \times 100\%$
Where:

• (\text{Current Period EPS}) = Earnings per share for the most recent period.
• (\text{Prior Period EPS}) = Earnings per share from a comparable earlier period (e.g., previous quarter or year).

Revenue Growth Rate:
$\text{Revenue Growth Rate} = \left( \frac{\text{Current Period Revenue} - \text{Prior Period Revenue}}{\text{Prior Period Revenue}} \right) \times 100\%$
Where:

• (\text{Current Period Revenue}) = Total revenue for the most recent period.
• (\text{Prior Period Revenue}) = Total revenue from a comparable earlier period.

A consistently high percentage for these rates, typically above the industry average, indicates a company acting as a growth stock. These figures are usually found in a company's financial statements.

Interpreting the Growth Stock

Interpreting a growth stock involves assessing its potential for sustained expansion and understanding the market's expectations embedded in its valuation. Growth stocks are often characterized by high valuation multiples, such as a high price-to-earnings ratio (P/E ratio), because investors are willing to pay a premium for anticipated future earnings rather than current profits. A high P/E ratio for a growth stock suggests that the market has strong expectations for significant future earnings growth.

However, interpreting a growth stock goes beyond just high ratios. It requires a deep dive into the company's competitive advantages, market opportunity, and ability to execute its business plan. A company may show high revenue growth, but it's crucial to assess if this growth is sustainable and eventually translates into profitability and positive cash flow. Investors also examine management quality, innovation pipelines, and the potential for expanding market capitalization to truly understand the prospects of a growth stock. Careful fundamental analysis is paramount to distinguishing genuine growth potential from speculative hype.

Hypothetical Example

Imagine a newly publicly traded software company, "InnovateTech Inc.," which had its initial public offering (IPO) two years ago. InnovateTech specializes in AI-driven enterprise solutions and has consistently reported revenue growth of over 30% year-over-year, far exceeding the industry average of 10%. Last year, its earnings per share (EPS) grew by 25%. The company reinvests almost all its earnings into research and development, marketing, and expanding its sales force, opting not to pay dividends.

Investors view InnovateTech as a prime growth stock. Its current price-to-earnings ratio is 60, significantly higher than its mature competitors, whose P/E ratios hover around 15-20. This high P/E reflects the market's confidence that InnovateTech will continue its rapid growth trajectory, capture a larger market share, and eventually generate substantial profits that will justify its current valuation and lead to further capital appreciation for shareholders.

Practical Applications

Growth stocks are a core component of many equity investment strategies, particularly for investors with a higher risk tolerance and a longer investment horizon. They are frequently found in sectors characterized by rapid innovation and expanding markets, such as technology, biotechnology, and renewable energy. For instance, companies like Shopify, MercadoLibre, and Roku have been cited as examples of growth stocks due to their continued expansion and increasing revenues in the e-commerce and streaming sectors.⁵

In portfolio management, growth stocks are used to seek substantial capital appreciation. While they may not provide immediate income through dividends, their potential for significant price increases can lead to considerable wealth accumulation over time. Regulatory bodies, such as the Securities and Exchange Commission (SEC), even have specific rules and scaled disclosure requirements for "Emerging Growth Companies" (EGCs), acknowledging the unique characteristics and capital-raising needs of young, rapidly expanding businesses.⁴,³

Limitations and Criticisms

Despite their appeal, growth stocks come with notable limitations and criticisms. One primary concern is their inherent volatility. Their high valuations are often based on future expectations, making them particularly susceptible to market downturns or any signs that a company might not meet its projected growth rates. If a growth stock fails to live up to these high expectations, its price can fall sharply.²

Another criticism is the absence or low payment of dividends, which means investors do not receive regular income and rely solely on capital appreciation. Furthermore, identifying true growth stocks requires extensive fundamental analysis to differentiate between genuinely innovative companies with sustainable advantages and those that are merely fashionable. Even renowned investors like Warren Buffett have cautioned against overpaying for growth stocks, emphasizing that growth projections can often be overly optimistic. Academic research has also explored the risk associated with growth stocks, particularly the notion that while they promise higher future earnings, this growth can be riskier and not always realized, leading to potential "value traps."¹

Growth Stock vs. Value Stock

The distinction between a growth stock and a value stock lies primarily in their investment characteristics and the underlying philosophy of the investors attracted to them.

While often seen as opposing investment strategy styles, some investors argue that the two concepts are intertwined. The "growth at a reasonable price" (GARP) strategy attempts to combine elements of both, seeking growth companies that are not excessively overvalued. For successful portfolio management, investors might consider a degree of diversification across both growth and value styles.

FAQs

Are growth stocks risky?

Yes, growth stocks are generally considered riskier than other types of stocks because their valuations are heavily based on expectations of future performance. If these companies fail to meet their high growth projections, their stock prices can experience significant volatility and sharp declines. Investing in growth stocks requires a higher risk tolerance.

Do growth stocks pay dividends?

Typically, growth stocks pay little to no dividends. Companies categorized as growth stocks usually reinvest most, if not all, of their earnings back into the business to fund expansion, research and development, and market penetration, aiming for accelerated capital appreciation rather than immediate income distribution.

How do you identify a growth stock?

Identifying a growth stock involves looking for companies with consistently high revenue and earnings per share growth rates, often exceeding industry averages. Key indicators include a high return on equity, a strong competitive advantage (like a unique product or technology), significant market opportunities, and a management team focused on innovation and expansion. Fundamental analysis of their financial statements is crucial.

Why do growth stocks have high P/E ratios?

Growth stocks often have high price-to-earnings ratio (P/E ratio) because investors are willing to pay a premium for the company's anticipated future earnings. The high P/E reflects the market's expectation of rapid and sustainable earnings growth that will eventually justify the current elevated stock price.