Growth stocks are shares of publicly traded companies that have a higher growth rate than the market average of their industry. Generally, they are innovative companies that offer unique products and services, which help them outpace competitors.
As a result, most of their earnings are invested in innovation and development, leaving investors with low prospects of receiving dividends, but with strong expectations of high capital gains. traders should be aware that growth stocks are more volatile, and a fair analysis of each company is needed before investing.
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What are Growth Stocks? A Short Definition
Growth companies are those that have a high prospect for sales and earnings growth in the future. These firms can grow at a faster pace than the rest of the markets, as they invest more of their revenues towards business development. All market sectors have growth companies, though, they are more present in the following business sectors: technology, biotechnology, and renewable energy.
Most of the growth companies offer innovative services and products that are considered to have a big impact on the markets in the future. As a result, the most successful ones can provide high capital returns for investors, while the less fortunate ones can generate losses.
Characteristics of a Growth Stock
- Strong growth rate
Growth stocks tend to have a higher increase in sales and earnings than the market average. As a result, their stock value is growing faster than the average stock in the market.
For example, Amazon (AMZN) has increased its stock value from USD 1898 in early January 2020, to USD 3186 in December 2020, almost doubling in value, as compared to the Dow Jones Industrial Average (DJI) which increased by 5% in the same time period, so it can be considered a high growth stock.
- Low or zero dividends
Typically, growth stocks do not pay dividends, or they pay small amounts. This is because these companies are growing at a fast pace, and they have to reinvest their profits to develop and expand their business. In the long term, this will help them boost revenues, attract new customers and ultimately, enhance their stock price growth.
A good example is Alphabet (GOOGL), the parent company of Google, which has never paid investors a dividend since it was incorporated in 2004.
- Loyal customer base
The innovative and usually unique products and services provided by growth companies offer them a loyal and increasing customer base. This represents the foundation for acquiring new customers, thus further enhancing the growth of the firm.
For example, Apple (AAPL) has some of the most loyal customers in the smartphone market, with an almost 90% brand loyalty, making them one of the most important technology brands in the world and one of the growth stocks to buy.
- Competitive advantage
Growth companies generally have a competitive advantage over other firms within the same industry. This can mean either that they are the first to provide a product or service, or that they have the ability to attract and keep the largest number of users. As a result, growth companies experience larger gains than other firms operating in the same industry.
For example, Netflix (NFLX), is one of the first streaming services available, which still holds the largest number of users. The company is now challenged by platforms such as Disney+ and Amazon Prime Video, all of them trying to attract new subscribers.
- High P/E ratio
In most cases, growth stocks are trading at a high P/E (profit to earnings) ratio, making them look expensive for investors. Though, assuming the fact that the firm continues to grow, these valuations can be considered low.
One of the highest P/E ratios on the market is from Tesla (TSLA), with a P/E ratio of over 1200, making it very expensive, especially when compared to other companies such as General Electric (GE) which has a P/E ratio of only 30.
- Capital gains
As growth stocks generally pay little or no dividends, investors do not make high profits in the short term. On the other hand, the long-term prospects are quite different. Traders can make high profits through capital gains, by holding the stock for a long period, as a growth firm usually has strong and sustained increases in its share price.
A growth stock example is Facebook (FB), which has yielded investors a solid capital gain since it was listed in 2012, at USD 38, as compared to the current stock value of over USD 280.
How to Find Growth Stocks?
Traders that want to invest in growth stocks can try to identify products and services regularly used today, that were not available in the past. In addition, investors should take a look at the companies behind the services and products that started to gain traction in recent years and that are widely used in everyday life, such as Uber for transport, and Amazon for online shopping. In order to make a successful investment, traders can look to new companies that are early in the growth cycle, such as Zoom Video (ZM), which may show sustained growth over the next years.
Another way to find growth stocks is to look at macro societal trends. The firms that can benefit from a trend can see their earnings and profits grow for years to come, thus generating higher returns for investors. One important market trend is fintech, where companies such as PayPal (PYPL) are transforming the way money is transferred, used for online shopping, and online credits.
Traders can spot growth stocks by ticking the following parameters:
- Earnings and profit growth of over 10% over the past five years, or for the last available period;
- Sales growth of over 10% over the past five years, or for the last available period;
- Profits in the last financial year, with profit prospects for the year to come;
- Profits expected to grow with over 15% in the next year;
- User base increase of at least 10% year-on-year for the last five years, or for the last available period;
- Low or zero dividend pay-out policy;
- High P/E ratio.
Risks of Investing in Growth Stocks
- Company fails to perform in the future
Investors that hold growth stocks must keep in mind that most of their profits come from capital gains in the long term, rather than dividends. As a result, if the firm fails to perform in the future, traders can have losses.
- Losing competitive advantage
One of the highest risks of investing in a growth stock, especially in a small-cap stock is the loss of competitive advantage for the products and services offered by the firm.
- High volatility
Growth stocks are riskier than other types of stocks as they are issued generally by young companies, that do not have a track record which investors can easily follow. This makes them riskier to invest in, as their stocks can offer traders high returns, as well as disappointing valuations.
Examples of Growth Stocks
Based on our analysis above, we’ve compiled a list of examples of growth stocks to buy:
- Amazon (NASDAQ:AMZN);
- Netflix (NASDAQ:NFLX);
- Facebook (NASDAQ:FB);
- Tesla (NASDAQ:TSLA).
- Apple (NASDAQ:AAPL);
- Zoom Video Communications (NASDAQ:ZM);
- Alphabet Inc Class A (NASDAQ:GOOGL);
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