What is a growth stock? It’s a question I get asked a lot and honestly, there isn’t a set-in-stone definition that everyone agrees with. In theory, a growth stock is a company that has the potential for massive growth in the future. Growth stocks are always valued based on their future potential earnings. Since most, if not all of them are not profitable at this stage, traditional multiples are difficult to use. Growth stocks are a sharp contrast to value stocks which are well-established, profitable companies that are selling below their intrinsic value. These value industries include sectors like banking, retail, and commodities.
Is Growth Just Another Way of Saying Tech?
So is there a specific multiple or sector that clearly makes a company a growth stock? Not exactly. Everyone will have their own definition, based on risk tolerance and what you believe are appropriate valuations for stocks you want to invest in.
Generally speaking, though the formula for growth stocks vs value stocks is clear. Growth stocks have high price multiples, are unprofitable, and are rapidly expanding their current business. Perhaps most of all, growth stocks have the potential to outgain the markets over the long term.
So yes, most growth stocks are either tech stocks or have a tech component to the business. No, not all growth stocks are tech stocks, but most tech stocks are growth stocks. Does that make sense?
Because the tech industry and most tech companies are relatively young, they haven’t established themselves as most value stocks have. We have seen exactly why investors love to buy tech companies in their infancy. Imagine investing in shares of companies like Apple, Amazon, or Alphabet when they were just starting out. Growth stocks can be risky, but they also have the highest potential gains to be made in the long run.
What Makes a Growth Stock?
As I already mentioned, growth stocks tend to have some pretty specific parameters although not all stocks are the same. Generally speaking, these indicators are what analysts and investors use to determine a growth stock.
High Price Multiples
So what exactly does this mean? We see and hear the mention of stock valuations and multiples all the time. When we talk about growth stocks, we are primarily looking at price multiples.
This is the relative ratio between the price of the share and various aspects of the company.
For example, the price to earnings or price to sales ratio is cited to give a clear picture of the current state of the business. For reference, most value stocks trade with a price to sales ratio near 1.
Most growth stocks have ratios in the double digits. For price to earnings, the average company in the S&P 500 has historically been around 15.
Compare that to one of the most popular growth stocks in Tesla, which has a price-to-earnings ratio of about 300.
While this seems to carry a negative connotation with investors, it really isn’t. Amazon was given flack for years because it wasn’t profitable until it was. Now it’s one of the most powerful companies in the world because it reinvested all of its revenues into the growth of the company. Unprofitability comes with the territory for new businesses, and expenses are high for tech sectors. Don’t worry if a company you want to invest in isn’t profitable right now. Just make sure it is on the right track to be profitable one day in the future.
Potential for High Growth
This seems obvious, doesn’t it? The definition of a growth stock is that you believe it will grow faster than the average returns of the market. With high growth comes high volatility. But it is in that volatility where massive, market-beating gains are made. If you are a high-growth investor, you want to see those parabolic stock charts. The stock market is a forward-looking market, so any stock with high potential growth will usually see that in its stock price.
It is very rare for a growth stock to have enough cash flow to pay out a dividend to its shareholders. As an investor, you aren’t buying shares of a growth stock for its dividend though. On the other hand, most value stocks can afford to pay out a dividend. This is because they are likely cash flow positive and can add in a dividend to offset the slower growth of the stock.
What Are the Risks of Growth Stocks?
The number one risk with growth stocks is that the company’s growth slows or changes trajectory. At the time of buying the stock, investors are looking ahead to the long-term potential of the company.
If that potential suddenly changes or if the direction of the company is altered, then you can expect the stock price to fall. Growth stocks have a lot of future growth priced into the stock already.
Shareholders will not hesitate in selling the stock if the future outlook becomes less appealing.
A good example of this would be for a biotech company that has a potential new drug in a clinical trial. Investors buy the stock now thinking that if the trials are successful, the stock will skyrocket. But if the results of the trials fail, then you better believe that the stock price is going to tumble.
What are the Benefits of Growth Stocks?
Again, much of this discussion will depend on your personal investment strategies and investing goals. You might see the risks above and think it’s not worth your time or money. Meanwhile, a growth investor will likely see that the benefits outweigh the risks in this situation. Those exponential gains make the risk of the stock falling worth it. As always, you should be doing your due diligence and researching the potential pitfalls of every company.
Using the biotech example from above, what if the clinical trial results were excellent? The stock price could soar and potentially double or triple. On top of that, the company now has a recurring revenue stream for as long as they own the patent. The fortunes of an entire company can flip on one successful trial. Buying in early on a growth stock could mean you own shares at pennies to the dollar. Growth stock investing can be life-changing in a way that value stock investing cannot.
What are the Best Growth Sectors?
It would be easy enough to just answer tech here, but tech itself is more of an umbrella term. For growth sectors, you want to target markets that are secular trends with high adoption around the world. Technology is meant to make things easier for us, so I like to target companies that we cannot live without.
As much as people despise being used for their data, it is nearly impossible to live our lives without big tech companies.
The smartphone industry alone is essentially a dichotomy between Alphabet’s Android and Apple’s iPhone.
There’s a reason why these companies are the most valuable in the world. We can’t live without them, and that’s why they make for excellent investments.
I know these two sectors aren’t the same thing, but they’re both after the same goal of improving human life. These companies are some of the most speculative on the markets and can surge or dive on the slightest news. I do like that both sectors are involved in trying to cure diseases for the betterment of humanity. These are also sectors where you really need to follow the progress of the company. They have the potential to make or break your portfolio so tread wisely and do your due diligence.
Global adoption? Check. Improvement on existing technology? Check. Buy in from governments and consumers? Check. Electric vehicle stocks have been some of the hottest on the market over the past couple of years. They are also the definition of a growth stock with high long-term potential but near-term unprofitability. Electric vehicles are here to stay, and so should their stocks in your portfolio!
Conclusion on What is a Growth Stock
Growth stocks are exactly as their name indicates: companies that have the potential for high growth in the future. Quintessential growth stocks also come with some fairly set parameters. These include trading at high price multiples, usually being unprofitable, and using any cash flow to rapidly scale their business. You are not investing in the company for what it is now, but for the potential of what it could be. Growth stocks do come with some volatility though and are inherently riskier than value stocks. The risk/reward will likely determine your investing style, and can provide huge losses or life-changing gains.