As an investor, it makes sense to consider the value of putting money into growth stocks. After all, growth stocks are companies that are expected to outpace their peers in terms of earnings and stock performance.

While these stocks don’t usually pay out a dividend, the returns can be exponential. And as growth stock companies grow, they can even emerge into a dividend-paying company in the future.

Key Takeaways

  • Growth stocks are companies that are expected to outpace their peers in terms of earnings and stock performance.
  • Growth stocks provide for a multitude of both short-term and long-term opportunities for investors.
  • When investors are researching growth stocks, they should identify companies that have a strong leadership team, a good growth market, a record of strong growth in sales, and a large target market.

When researching growth stocks, investors will soon discover that not all growth stocks are created equal; the good news is that this provides for a multitude of both short-term and long-term opportunities when investing in growth stocks.

When it comes to the winners, they often share many of the same characteristics: a strong leadership team, good growth prospects, or an innovative idea. It is these characteristics (plus a few more) that investors can be on the lookout for.

A Strong Leadership Team

Because growth companies are focused on increasing the profits and sales of the organization, the management team is going to matter a lot. Growing a company requires an innovative leadership team. Without it, growth won’t happen. 

Growth investors, looking for their next investment, will want to choose companies that have a leadership team with a good track record and a reputation for being innovative. Think of Steve Jobs and Bill Gates as innovative company founders.

While it may not be easy to spot the next innovator, investors definitely should do some research on the leadership team before investing any money in the stock. The last thing anyone wants is to get stuck with a company that’s following the pack instead of leading. Or possibly even worse: will be gone in six months to a year. While great leaders have been known to post short-lived successes, taking a look at a company’s management team before making a growth investment can be an easy way to weed out some potentially high risks.

A Good Growth Market

For any sized company to grow, it is going to have to play in a market that’s poised for growth or is already in growth mode. If the industry is at the tail end of its growth trajectory, it isn’t considered a growth market. For example, today may not be the best time to invest in a personal computer (PC) hardware vendor but it could be the right time to get in on a mobile app start-up.

In addition to operating in a high growth industry, the stock you choose has to have a commanding market share. You don’t want to get stuck with the third or fourth player in an emerging growth market. Nor do you want a one-trick pony, which means investors should look for companies that will be able to sustain their competitive advantage. Is the company coming out with many innovative, successful products? Or does it continue to ride its first success? These are questions investors need to consider.

A Record of Strong Growth in Sales

While the industry, leadership, and market share of a stock all matter a lot, it's important to also consider the sales of the company. You want a company that is seeing an acceleration in earnings and revenue growth for constructive quarters (rather than one that has had irregular or slowing growth).

The faster the growth rate, the higher the likelihood the stock will rise. After all, companies that are boosting sales and earnings are going to be attractive investments for investors. When it comes to the growth rate of a winning stock, there isn’t any hard and fast rule. However, you do want to go with a company that has at least high double-digit growth.

Many high-flying growth stocks see triple-digit growth rates in the beginning and a slower growth rate as the company and industry matures. Diligence in assessing the growth can also be important–since double-digit sustained growth can be a great characteristic for a growth company–but if it’s the fifth year of that growth there may be less viability. Thus, identifying companies with high sales growth at the onset of a market breakthrough or new management strategy can be essential.

Avoid Overvalued Stocks

Growth stocks are attractive to many investors because they are growing. But that doesn’t mean you should overpay for a growth stock either. Growth investors want to avoid those stocks that have a big run-up because of investor demand or because fundamentals have declined but the stock price hasn’t.

Growth stocks that are overvalued will likely see shares decline and eventually trade at a price that reflects its current fundamentals. All of this equals bad news for growth investors. Price-to-sales ratio (P/S) and price-to-earnings (P/E) ratio can be two good ratios to take a quick look at when thinking about a growth stock. A reasonable P/S ratio with the expectation for high sales growth can be a good sign for the future stock price. A flat P/E to forward P/E or a forward P/E that is below the historical average can also mean the stock has a great deal more room to move higher.

Large Target Market

Nobody gets rich selling a niche product to a handful of customers. For any business to grow, they need a large target market to hawk their wares to. For growth investors, the companies that are serving huge markets are the ones to go after. The bigger the pool of potential customers the greater the chance of success there is. For example, consider Apple and the iPhone. Without a massive market, the iPhone wouldn’t have seen so much continued success.

The Bottom Line

Growth investing can often be most attractive in a healthy economy where companies are benefiting from increased demand and a rise in corporate and consumer spending. However, certain key factors can help a growth company do well in all types of economic environments.

Broadly, companies that are seeing their growth accelerate will often see their stock go up as well. But not every growth company is the same, which means heightened risk assessment and ongoing active awareness of growth investments is necessary. Growth investments can reap some of the greatest rewards but also pose some of the highest risks. Knowing how to identify the best ones and their market longevity can easily narrow the universe and result in a higher portfolio return.