What are growth stocks?
Editorial staff, J.P. Morgan Wealth Management
- Growth stocks are shares in companies that are expected to grow faster than the stock market as a whole.
- Growth stocks generally have higher price-to-earnings (P/E) ratios than other stocks, and they rarely pay dividends.
- These stocks are often contrasted to value stocks, which are company shares that are trading at a lower price than the company’s fundamentals (like its earnings, dividends or book value).
Growth stocks are shares in companies expected to grow at an above-average rate compared to other publicly traded companies.
Elyse Ausenbaugh, J.P Morgan Wealth Management’s Head of Investment Strategy, describes a growth stock’s value as “about what investors perceive about the company’s future potential.”
Examples of growth stocks might be shares in high-profile technology companies or biotech firms at the vanguard of new therapies and medical technologies. Artificial intelligence companies may also fall into this category.
If a company is behind a revolutionary new product – or they create an entirely new market as a result – investors may expect them to grow substantially and relatively quickly. And that, in simple terms, is how a growth stock comes to be.
In this article, we’ll cover what a growth stock is and how investors interested in growth stocks may try to identify valuable growth stocks in the market.
Remember as you consider growth stocks or other investments: Investing involves market risk, including possible loss of principal, and there is no guarantee that investment objectives will be achieved.
How to recognize growth stocks
There’s no surefire method for identifying stocks that will grow at above-average rates. Investors interested in growth stocks generally search for companies that not only have great ideas but ones that can also bring those ideas to market while outperforming competitors. This is why growth stocks are often found in the tech sector and its sub-sectors, in which ongoing innovation is a key driver of value.
If a company looks like it might generate above-average earnings growth, it will attract investors who are looking to profit on stock price increases as the company expands. Here are some key characteristics of growth stocks that these types of investors look for.
Rapid scaling
Growth-oriented companies usually don’t pay dividends on their stock and instead put profits back into the business. Historically, growth companies try to scale up fast, increasing their headcounts rapidly and perhaps even opening offices around the country or around the world.
Because these companies may not show profitable margins for years (or decades) as they grow their businesses, stock analysts often review other metrics to determine whether companies with these profiles shows promise. The characteristics they look for may include the value of their copyrighted intellectual property, their revenues and the loyalty of their customers.
High multiples
Some investors look at a company’s “multiples,” or a set of commonly accepted ratios for assessing company value, to determine whether the company is growing and if the market thinks the company will grow even faster.
The P/E ratio shows how expensive a stock’s price is relative to the company’s earnings, and the price-to-book ratio shows the market capitalization of a company compared to the value of its assets minus its liabilities.
Growth companies generally have “high” multiples, which means the value of its earnings or its assets is small compared to its share price. For growth investors, high multiples are a sign that the stock market believes the future value of this company’s earnings and assets will be much greater in the future.
Disruptive potential
Past growth stocks have included breakout tech companies that transformed the way we shopped, communicated and traveled. Businesses that consider themselves disruptors of a settled market using new technology rely on phenomenal growth to attract investors to their stocks. This “disruptor” factor is something investors try to assess when evaluating growth stocks.
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Potential benefits of growth stocks
A growth stock’s main benefit largely comes from its potential capital appreciation. Here’s a breakdown of some of the key advantages.
- Capital gains potential: If you buy a growth stock before it grows to dominate its market and industry, you stand to make very large capital gains
- Innovation-driven opportunity: Many growth companies operate in future-facing industries and sectors. While there is greater risk, there is also the potential to be part of a whole new industry or a future industry-leading company.
- May diversify an investment portfolio: Growth stocks may help you create a balanced portfolio in combination with investments that are perceived as being safer as you grow your investments over time
- Compound growth benefits: Growth companies are more likely to reinvest their earnings back into their operations rather than pay dividends. This means that they may experience compounding growth, driving even greater growth potential.
Potential risks of growth stocks
Of course, not all companies with great business plans or breakout products are great long-term investments. In fact, some companies that appear to have great growth stories may not be wise investment choices. Some companies, which at one time were considered high-growth and valued at billions of dollars, ended up being traded for pennies after their businesses failed to maintain their initial period of rapid growth.
Here are some of the risks associated with growth stocks to consider.
- Mispriced growth potential: The stock market has occasionally mispriced future growth, including periods of irrational exuberance – like during the dotcom bubble that burst in 2000.
- Market sentiment over business fundamentals: Growth stocks may appreciate because the market thinks the underlying company will appreciate, not because the business will actually grow to justify the lofty stock price
- Increased volatility: Growth stocks often experience more dramatic price swings than value stocks or the overall market
- Competitive pressures: High-growth sectors may attract intense competition. These companies must constantly innovate and adapt, making it challenging to maintain their competitive edge and growth trajectory over the long term.
Growth stocks vs. value stocks
Stocks may be classified as “value” as opposed to “growth” when they hold value that isn’t represented in their current share price. Consequently, value investing isn’t just about buying shares in a good company that has real income (although that may be a part of it) but more so expressing faith that the market will reward the company’s stock value with a higher share price when it recognizes its value eventually.
Investors who are deciding whether to buy growth or value stocks need to consider their current investment strategy, risk profile and expectations.
The risk profiles for these two kinds of stocks are distinctly different. Growth stocks are generally more volatile and susceptible to market sentiment and shifts in investor expectations. A growth stock’s price can suffer significant declines if it doesn’t meet investors’ expectations.
Conversely, value stocks tend to be more stable and less sensitive to market downturns, because they are often already considered to be undervalued. Investors in value stocks may experience less downside risk during market corrections and benefit from steady gains as the stocks revert to their intrinsic value.
Growth stocks are often concentrated in sectors experiencing rapid technological advancements and market expansion, which may make them more vulnerable to sector downturns. Identifying value stocks, on the other hand, presents its own challenges. While they tend to be more diversified across industries, pinpointing true value stocks requires careful analysis to distinguish between undervalued opportunities and companies in long-term decline.
Growth stocks vs. dividend stocks
Growth stocks are characterized by their potential for significant price appreciation. In contrast, dividend stocks are often associated with well-established companies in mature industries, which return a portion of their profits to shareholders through dividend payments. The dividends paid by these companies can be a reliable source of income, and dividend stocks historically exhibit less price volatility compared to growth stocks.
This stability, combined with regular dividend payments, may be particularly appealing during economic downturns or volatile market periods.
The investment horizon and risk tolerance of an investor are crucial in deciding between growth and dividend stocks. Growth stocks are more suitable for investors who have a higher risk tolerance and a longer investment time frame, allowing them to ride out volatility and potentially achieve gains from substantial stock increases.
On the other hand, dividend stocks may be preferred by investors hoping to earn regular income on their investments and are more risk-averse, appreciating the dual benefits this type of stock offers.
The bottom line
When considering what a growth stock is and whether a particular stock makes sense for your portfolio, think about your risk appetite and investing horizon. Keep in mind that while a buzzworthy new company may seem promising, growth stocks are typically riskier investments. Consult a financial advisor for questions on how to incorporate growth stocks into your current investment strategy.
FAQs
A growth stock mutual fund is a fund – either an actively managed fund or a passive index fund – that invests primarily in growth stocks.
To find the growth rate of a stock, you typically focus on its compound annual growth rate, which is a formula to determine the growth of a stock looking at a particular time frame. Investors may also analyze other growth metrics, like revenue growth rate, earnings per share growth and dividend growth.
Typically, growth stocks do have high P/E ratios because their perceived future value is reflected in the stock price and not in the company’s earnings.
Generally, growth stocks do not pay dividends. That’s because these types of companies typically opt to reinvest profits back into the business to accelerate growth. However, there are exceptions.
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Editorial staff, J.P. Morgan Wealth Management
