What Is a Growth Stock?

A growth stock is any share in a company that is anticipated to grow at a rate significantly above the average growth for the market. These stocks generally do not pay dividends. This is because the issuers of growth stocks are usually companies that want to reinvest any earnings they accrue in order to accelerate growth in the short term. When investors invest in growth stocks, they anticipate that they will earn money through capital gains when they eventually sell their shares in the future.

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Explaining Growth Stock

Key Takeaways

  • Growth stocks are those companies expected to grow sales and earnings at a faster rate than the market average.
  • Growth stocks often look expensive, trading at a high P/E ratio, but such valuations could actually be cheap if the company continues to grow rapidly which will drive the share price up.
  • Since investors are paying a high price for a growth stock, based on expectation, if those expectations aren't realized growth stocks can see dramatic declines.
  • Growth stocks typically don't pay dividends.

Understanding Growth Stocks

Growth stocks may appear in any sector or industry and typically trade at a high price/earnings (P/E) ratio. They may not have earnings at the present moment but are expected to in the future.

Investment in growth stocks can be risky. Because they typically do not offer dividends, the only opportunity an investor has to earn money on their investment is when they eventually sell their shares. If the company does not do well, investors take a loss on the stock when it's time to sell.

Growth stocks tend to share a few common traits. For example, growth companies tend to have unique product lines. They may hold patents or have access to technologies that put them ahead of others in their industry. In order to stay ahead of competitors, they reinvest profits to develop even newer technologies and patents as a way to ensure longer-term growth.

Because of their patterns of innovation, they often have a loyal customer base or a significant amount of market share in their industry. For example, a company that develops computer applications and is the first to provide a new service may become a growth stock by way of gaining market share for being the only company providing a new service. If other app companies enter the market with their own versions of the service, the company that manages to attract and hold the largest number of users has a greater potential for becoming a growth stock.

Many small-cap stocks are considered growth stocks. However, some larger companies may also be growth companies

Growth Stocks vs. Value Stocks

Growth stocks differ from value stocks. Investors expect growth stocks to earn substantial capital gains as a result of strong growth in the underlying company. This expectation can result in these stocks appearing overvalued because of their generally high price to earnings (P/E) ratios.

On the contrary, value stocks are often underrated or ignored by the market, but they may eventually gain value. Investors also attempt to profit from the dividends they typically pay. Value stocks tend to trade at a low price to earnings (P/E) ratio.

Some investors may try to include both growth and value stocks in their portfolio for diversification. Others may prefer to specialize by focusing more on value or growth.

Some value stocks are underpriced simply due to poor earnings reports or negative media attention. However, one characteristic that they often have is strong dividend-payout histories. A value stock with a strong dividend track record can provide reliable income to an investor. Many value stocks are older companies that can be counted on to stay in business, even if they aren’t particularly innovative or poised to grow.

Example of a Growth Stock

Amazon Inc. (AMZN) has long been considered a growth stock. In 2020, it is one of the largest companies in the world and has been for some time. As of March 31, 2020, Amazon ranks in the top three U.S. stocks in terms of its market capitalization.

Amazon's stock has historically traded at a high price to earnings (P/E) ratio Between 2019 and early 2020, the stock's P/E has remained upwards of 70. Despite the company's size, earnings per share (EPS) growth estimates for the next five years still hover near 30% per year.

When a company is expected to grow, investors remain willing to invest (even at a high P/E ratio). This is because several years down the road the current stock price may look cheap in hindsight. The risk is that growth doesn't continue as expected. Investors have paid a high price expecting one thing, and not getting it. In such cases, a growth stock's price can fall dramatically.