A growth stock is a company expected to rise faster than the overall market, offering bigger gains for investors who don't mind risk

Simon ChandlerJan 16, 2021, 00:18 IST

Business Insider

Growth stocks offer larger gains than other stocks, so they're valued by investors seeking substantial appreciation in their portfolios.Caroline Purser/Getty Images

Growth stocks are equities that outperform the market, their share prices increasing at a faster pace.
Growth stocks are often companies in innovative fields. They have high earnings but don't pay dividends.
Growth stock share prices can be inflated and swing sharply, especially with young, unproven firms.

Most investors want the stocks they buy to grow or appreciate as the financial pros say. But some stocks appreciate a lot more than others.

This is particularly the case with so-called growth stocks - equities that generally increase in value more rapidly than the average. They outpace the stock market, in other words.

They have a lot of appeal and get a lot of press. But as with any investment, they have drawbacks as well. Let's go through the ups and downs of growth stocks.

What is a growth stock?

"Growth companies or stocks typically have a recent history of growing or are expected to grow their revenues and profits at a faster pace than the market," says Niladri Mukherjee, the head of CIO portfolio strategy at Merrill Lynch. "They tend to operate in newer and faster-growing industries and are disrupting traditional ways of doing business."

For investors, growth stocks are the fuel that drives the appreciation of their portfolios - the big winners, or at least, the potential winners. However, they tend to be riskier than other kinds of stocks: Their higher-than-average prices increase the risk of a larger drop in the event that their companies' earnings don't match expectations. And that can be common, as many are fairly young companies, promising but untried.

Key traits of growth stocks

Growth stocks don't only grow fast. They also exhibit a range of other distinguishing characteristics.

Market-beating growth

Obviously, growth stocks' number one trait is their rapid appreciation. Unfortunately, there's no specific rate that marks an equity as a growth stock. Instead, investors should look to market averages - indexes such as the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite - to decide whether a stock fits the bill. For example, the S&P 500 has grown by roughly 15% over the past year, while the Dow Jones has grown by nearly 7%. By contrast, Amazon - perhaps the most prominent growth stock today - has risen by 66%. Likewise, Apple has grown by 63% and Google by 20%.

Higher earnings per share and P/E ratios

Related to the increase of its stock price, the typical growth company also enjoys a high earnings-per-share growth rate. Basically, this means that its profits are growing faster than the market average, which is ultimately what leads investors to push up its stock price.

Taking Amazon as our example again, its EPS for Q3 2020 was 193% higher than the equivalent figure for Q2 2019. This is a figure the S&P 500 simply can't match, with even fairly optimistic projections from Goldman Sachs putting the S&P's EPS growth rate at 30% by the end of 2021.

Usually, a growth stock also comes with a higher-than-average price-to-earnings (P/E) ratio, which measures the price of a company's stock relative to its earnings per share. Higher P/E ratios indicate more expensive stocks, something you'd expect to see with growth stocks that promise to outperform the market.

For example, Tesla has an eye-watering P/E ratio of 1,444, while the Nasdaq Composite and S&P 500 average out at around 40. Its higher price is due mostly to an expectation that it will deliver higher future growth.

No dividends

Growth stocks tend not to pay out dividends to shareholders. Instead, they opt to plow any profits into back into production, expansion, or research and development.

In fact, that's one reason for their rosy outlook. "Growth stocks are anticipated to grow partly because firms reinvest any earnings," says Susannah Streeter, a senior investment and markets analyst at Hargreaves Lansdown.

Amazon has never paid a dividend, and neither has Google.

Hot young industries

Growth stocks can be found in any field, but most are in innovation-prone industries.

Many growth stocks can now be found in the tech sector. This is hardly surprising, given that the tech sector is the most disruptive industry operating today, producing companies that are innovating with new products and business models.

Another example is the renewable energy sector, with Tesla perhaps being the most famous (or notorious) company in this bracket, having risen by 690% over the past year. Danish multinational power company Orsted (DNNGY) is another notable growth stock in this area, having risen by just under 100% over 12 months.

Online retail and fintech are two other examples of growth sectors. Here, prominent companies include Alibaba, JD.com, eBay, Rakuten, Zalando, and Groupon, as well as PayPal, Square, Green Dot, and MercadoLibre.

Still another area where you're likely to find growth stocks is in emerging markets, meaning nations or geographical regions where businesses are growing more rapidly than their equivalents in more mature economies. This includes BRIC countries such as Russia and China, where the likes of Gazprom, China Mobile, Taiwan Semiconductor Manufacturing Co.. and Baozun are examples of growth stocks.

The downsides of growth stocks

Unfortunately, high risk is another characteristic shared by growth stocks. The leading disadvantages include:

Economic: Growth stocks are sensitive to business cycles - they perform particularly well during boom periods, and decline more sharply during busts. There was a dramatic demonstration of this tendency during the bursting of the dot-com bubble in 2000 and the ensuing 2001 recession. (That said, the era of the 2020-21 coronavirus pandemic seems to have bucked this trend somewhat, at least with tech- or digital-based growth stocks. They are performing well, despite the underlying stagnation of the economy overall.)

Expensive: It's easy for all the buzz to make a growth stock overvalued by the market. "Some companies and sectors can get hyped up by investors who drive their share prices to unjustifiable heights," says Susannah Streeter.

Volatile: Growth stocks have historically exhibited more volatility than other stocks, rising - and falling - in price more frequently. For example, Amazon's beta value, a measure of how much it moves relative to the stock market, is 1.20, while Apple's is 1.28. (The market overall scores 1.0.) This indicates that these stocks experience price swings more often than the overall market, exposing their holders to more potential losses as well as gains.

Unproven: While certain growth stocks have been around for decades (e.g. Apple, Amazon) and have a proven business model, others haven't. One example of this is the ridesharing Uber, which has had a bumpy road since it went public in 2019. Despite being higher than its opening price ($55 compared to $42), it continues to operate at a loss, having posted a 'net profit' of minus $8.5 billion in 2019.

Growth stocks vs. value stocks

Value stocks are in a sense the opposite of growth stocks. A value stock is one whose shares are trading below its company's intrinsic or fundamental worth. "Their share prices may have suffered due perceptions for weaker growth and cash flows, loss of competitive advantage, [or] declining industry fundamentals," says Niladri Mukherjee.

Compared to growth stocks, value stocks aren't anywhere near as exciting. However, they can provide an important complement to growth stocks. Many investors see them as good deals, undiscovered diamonds - in contrast to the premium prices you pay for a flashy growth stock. Though sleepy, value stocks are more stable. And of course, they've got potential to rise too, once the market realizes the company's sound fundamentals.

There has been plenty of debate over the decades about whether growth stocks or value stocks are "best." However, the truth boringly lies somewhere in the middle, with an approach diversified between the two usually being the wisest option.

"As value and growth tend to perform well at different times, owning a bit of both can help," says Susannah Streeter.

What are some of the top growth stocks?

It's hard to predict which stocks will become the next big growth stocks. However, it's easy enough to identify which stocks currently are growth stocks - the most successful.

They vary quite widely in terms of the ages and sizes. Apple, for example, was founded in 1976 and garnered $274.5 billion in revenue in 2020, while Tesla was founded in 2003 and had revenue of around $28 billion in the 12 months prior to October 2020.

Amazon (AMZN)

Amazon exhibits pretty much all of the traits of the archetypal growth stock. It has grown faster than market averages for numerous years, rising by more than 400% over the past five years, compared to 95% for the S&P 500. It also has a higher-than-average EPS growth rate, doesn't pay dividends, has a high PE ratio, and operates in an emerging industrial sector (online retail).

Apple (APPL)

As with Amazon, Apple ticks most of the boxes for being a growth stock. It has also grown by more than 400% over the past half a decade, has a high PE ratio, and operates in the tech sector. On other hand, its projected EPS growth rate isn't much higher than market averages for the next few years, indicating that it may be maturing as a company.

Netflix (NFLX)

Netflix is another company that has demonstrated impressive growth, with its earnings per share rising by over 70% between 2019 and 2020. It has also seen its stock price rise by 49% over the past 12 months. It doesn't pay dividends.

Tesla (TSLA)

Tesla is something of a controversial growth stock, largely because its fundamentals don't appear to fully rationalize its staggering growth. For example, while it overtook Toyota in 2020 to become the world's biggest carmaker in terms of market capitalization, it sells nowhere near as many vehicles as its Japanese rival. Its EPS did grow by 69% between 2019 and 2020.

Square (SQ)

Founded in 2009, payments company Square is the youngest of the five growth stocks featured here, which may account for why it has experienced the most growth (save for Tesla). Its share price rose by 233% over the past year, although it's worth pointing out that its EPS actually shrank from 2020 and 2019, with the company making a loss of $0.18 per share in the months ending September 2020 (compared to a loss of $0.04 in 2019).

The financial takeaway

Growth stocks - which can be recognized by their greater volatility, higher EPS growth rates and lack of dividend payments - are a key part of any diversified portfolio. They offer investors greater potential gains, particularly during periods of economic expansion.

Of course, as with most high-reward investments, growth stocks correspondingly present greater risks. So, they should never be the sole focus of an investment portfolio. How big a presence they have among your holdings should depend on your long-term time frame, your overall goals, and your appetite for risk.

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