What Are Growth Stocks, and How Do They Work?

Discover the exciting world of growth stocks and learn how these riskier investment opportunities can lead to potentially substantial returns.

by | Last updated 8 Mar, 2023 | Investing Strategies

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Growth stocks are a popular destination for risk-seeking investors. These equities are typically younger businesses with immense long-term future earnings potential. As such, they often trade at lofty valuations and can enjoy significant upward momentum on positive results, unlocking lucrative capital gains.

This is the core of the growth investing strategy. And it’s how famous investors such as Philip Fisher and Thomas Rowe Price Jr became exceptionally wealthy.

What is a growth stock?

A growth stock doesn’t have as much of a clear-cut definition as value stocks. But as previously mentioned, these are companies capable of rapidly increasing revenue, earnings, or cash flow.

For mature enterprises, that’s much harder to deliver. As such, growth stocks are typically younger firms. But this also inherently makes them inherently riskier. After all, smaller businesses are more susceptible to macroeconomic and other external forces. And in many cases, they can be spectacularly unprofitable, making them dependent on external financing.

Furthermore, with investor excitement driving up the stock price well beyond fundamentals, production delays or revenue slowdowns can quickly send valuations plummeting.

Nevertheless, successfully identifying eventual industry titans in their early days is a proven recipe for generating ginormous portfolio returns.

What are the main characteristics of a growth stock?

As with any investment, there are a lot of factors to consider. And these can vary significantly between different economies and industries.

However, when hunting for growth stocks, there are several common traits that investors typically look for or expect to find.

  • High Growth Potential – Investors are willing to pay far beyond fair value because of the potential for extreme long-term growth. These companies may not control the lion’s share of their target markets. But they could be on track to eventually doing so, as reflected by ever-increasing sales figures.
  • Expensive Valuations – In most cases, growth shares trade at premiums above and beyond fair intrinsic value. As such, it’s not unusual to see a P/E ratio over 30 – more than double the S&P 500‘s average.
  • No Dividends – Younger enterprises usually don’t generate sufficient cash flows to afford a shareholder dividend. And the ones that do are often reluctant to offer payouts. After all, achieving growth requires capital. So, most growth stocks typically reinvest in themselves rather than redistributing excess cash flow to shareholders.
  • High Risk – When investing in shares that trade beyond intrinsic value, the risk of volatility drastically increases. Any missed earnings growth target or milestone can trigger rapid declines in valuations.

Advantages of growth stocks

While riskier than value investing, growth investing does offer several key advantages.

  • Lucrative Gains – The higher risks often mean higher potential returns. Even at a premium valuation, successfully identifying winning growth stocks can unlock tremendous wealth in the long term.
  • Exciting Investment Opportunities – Younger enterprises attempting to disrupt or revolutionise an industry can be a far more exciting and rewarding way to invest in the stock market.

Disadvantages of growth stocks

Of course, the advantages of growthier investments come with their own batch of drawbacks. And investors must consider the drawbacks before making any investment decision.

  • Expensive – The growth potential of a young business is not invisible to other investors. This is why valuations can reach unrealistic levels. Even if a growth company is successful, overpaying for its shares can still result in a bad investment.
  • Highly Volatile – Premium valuations open the door to increased share price volatility. If investor expectations aren’t met, share prices can quickly plummet.
  • Equity Dilution – For growth stocks reliant on external financing, issuing new shares is a popular method of raising capital. Why? Because a lack of cash flows makes debt financing far less viable. However, every time new shares are issued, it causes the earnings claim of existing shares to drop, dragging the share price down. This effect is only amplified when stock-based compensation is issued to employees. And is particularly common among tech stocks.

Growth stocks vs value stocks

Value investing is another popular strategy that is often considered the opposite of growth investing.

Instead of searching for the high fliers of the future, value investors are focused on finding businesses that are trading below their intrinsic value. While rare, in some situations, growth stocks can fall into this category.

It’s a far less exciting investing approach. But it’s proven to generate substantial returns in the long run. And comes with the added advantage of reduced share price volatility compared to growth stocks.

Warren Buffett is arguably the world’s most famous value investor building a net worth in excess of $100bn from simply buying and holding high-quality businesses at discounted prices.

Should I invest in growth or value stocks?

While there are strong proponents of both investing styles, the decision to focus on growth stocks or value stocks ultimately depends on the individual. Everyone has different investment goals, risk tolerances, and time horizons. And these can often dictate which path to take along an investing journey.

For example, an individual getting closer to retirement may not be comfortable taking on the excessive risk that comes with growth stocks. Similarly, a younger investor with a much longer time horizon may have a higher capacity for risk making investing in a value stock less attractive.

It’s also worth pointing out that there’s no rule against blending the two strategies together. Growth can be balanced with value to create a portfolio with tolerable levels of volatility while still offering an exciting and lucrative return on investment.

Other types of stocks

While value and growth stocks often get most investors’ attention, multiple alternatives exist.

  • Income Stocks – Shares that provide investors with a stream of (hopefully) reliable and consistent passive income through dividends.
  • Defensive Stocks – Shares of companies that operate in defensive industries less susceptible to economic fluctuations. Defensive stocks have historically outperformed during bear markets but underperformed during bull markets.
  • ESG Stocks – Shares of businesses that seek to add value to society, the environment, and employees while still generating positive returns for investors. ESG stocks are typically hunted by investors who want to build an investment portfolio that aligns with their personal morals and ethics.

The bottom line

Growth stocks promise the potential for immense capital appreciation. It makes them a desirable target for investors seeking riskier but potentially more lucrative opportunities within the stock market. While there’s never a guarantee of positive returns, growth investments can lead to impressive levels of wealth generation.

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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.

Written By

Prosper Ambaka, Esq.

Prosper is a self-taught financial analyst and investor with years of experience. Inspired by Benjamin Graham, he employs a value-investing school of thought throughout his analyses. This has led to Prosper developing a wealth of knowledge in equities, foreign exchange, commodities, and global macroeconomic issues.

In 2019, he completed his Law degree and was called to the Nigerian Bar in 2021. Outside The Money Cog, Prosper encourages others to join the investment community through his lectures on financial literacy as well as investing strategies.

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Edited & Fact Checked By
Zaven Boyrazian MSc

Zaven has worked in several industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.

Specializing in corporate valuation, Zaven employs a modern take on the principles set out by Benjamin Graham to find new opportunities at fair prices.

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