What Are Growth Stocks and Investing in Them A growth stock is a share in a company that is growing at a significant rate. Consequently, the stock price is expected to grow as well.
This story originally appeared on MarketBeat
A growth stock is a share in a company that is growing at a significant rate and often trades at a high valuation compared to a value stock. These companies might be in their earliest startup stages, or perhaps going through some aggressive expansion but, either way, growth is their focus. Because they are using their capital to invest in growth, they usually don't pay dividends. Instead, they'll reinvest their earnings back into the company to help it grow.
Many growth stocks are in startup industries that have blossomed in recent years, and may not have even existed a few decades ago. This could include biotech, cannabis, and artificial intelligence—but growth stocks can also be found in more traditional industries, such as transportation, energy, and entertainment. It all depends on the company issuing the stock and what they're doing.
Growth companies tend to have a uniquely singular product or product line, which facilitates their rapid growth beyond the rest of the industry. They may have proprietary technology, special access to certain resources, or incredibly growth-oriented management. Whatever the case may be, they'll want to continue to stay ahead of the competition, so there's a good chance they'll be reinvesting their earnings into research and development.
Another trait of growth companies is a loyal following or customer base for their product and may command a large market share. The trait of sizeable market share is what we've seen with some of the biggest growth stocks in the past few decades.
Amazon was once one of the only e-commerce sales venues where consumers could buy a wide variety of goods online. Facebook held a virtual monopoly on the concept of social media—and then bought up competitors like Instagram who entered their space. The proprietary technology at Google gave them the ability to outpace other search engines that had already existed for years. In all these cases, growth companies had a lockdown on a particular market, and the company grew exponentially within a short time.
The Benefits of Investing In Growth Stocks
Growth stocks are not known for paying out dividends but what they are known for is growth. If the company is worth $100 million and the stock trades at X dollars and then grows to $100 million it makes sense the shares would be worth 2X.
Investors might also hope a company might become an established, dividend-paying asset as well, but that is a very long-term view for most.
Companies in aggressive states of expansion might split their shares of stock, as well. They do this to increase the number of outstanding shares, which helps the share price stay low and attracts more investors so they can raise more capital. If you had bought just 10 shares of Apple in 1980, you'd find yourself today with 650 shares of this tech behemoth after the four splits it's gone through in the last 30 years.
Beware The Dangers of Growth Stocks
The biggest danger with growth stocks is getting in too early when they are totally unproven entities. They may project an appealing image that makes them stand out from the other cheap stocks to buy, but their business model could prove to be an epic failure or they could go bankrupt, or the market could be full of hype like the cannabis market was.
Growth stocks can also be overvalued. This is because they attract a lot of attention and their stock prices are based on expectations of future earnings. If those earnings materialize then good, the stock is not overvalued but if the earnings do not materialize share prices can implode.
Growth stocks can also be some of the most volatile stocks on the market which does not bode well for the average retail investor. Unequipped to analyze the waves of the stock market and know when to hop on and off, bumpy prices will take them for a harrowing ride—ultimately landing not too far from where they started and leaving them with minimal or negative profits. Stock trading is not for everyone, and knowing which stocks to buy now is a real blend of arts and sciences that takes years of trading experience.
A Guide To Growth Investing
Growth investing is sort of like drinking red wine—a moderate amount every day is good for your health, but too much is detrimental. A portfolio made entirely of growth stocks can wildly careen out of control especially if profits are taken when they are available.
That said, investors will want to invest a portion of their portfolio into growth stocks or use small allocations for each company within a growth stock portfolio.
This is actually a great strategy for younger investors who are just building their retirement portfolios. It's better to invest in risky assets while they're young, with decades ahead of them, because they have time to ride out the waves of the market and grow their money.
Some financial pundits warn against the inherently risky nature of growth stocks. Instead, they suggest buying stocks that have the potential for dividend growth. These dividend stocks or dividend growth stocks usually have a higher amount of earnings per share and are able to grow their dividends over time. They argue income stocks that pay dividends provide a better return on equity for long-term investing.
Dividend And Value Versus Growth Stocks
Value stocks may not be the most active stocks, but they tend to have great value as indicated by a lower price-to-earnings ratio. These companies have usually been around for a while and do not generate huge amounts of speculative excitement.
Beginning investors may wonder what is dividend yield and why it matters. The dividend yield is another strong indicator of a stock's value, in addition to the P/E ratio (price-to-earnings). The dividend yield formula is just dividing the dollar value of yearly dividends by the stock's share price). If a stock has a dividend yield of 4-6%, that's considered quite good.
A dividend investing strategy is the secret formula for some of Wall Street's wealthiest investors. If you own one share of a stock priced at $50, and the dividend yield is even just 3%, that company will pay you $3 every year from their earnings. That dividend might not mean a lot to a casual investor with ten shares, but if you owned 100,000 shares of that stock, it would generate a dividend of $3,000 annually for you. If you consider big investors like Warren Buffet owning millions of shares of stock, it's easy to see how dividend revenue alone can turn into a six-figure income.
Some stocks might be undervalued because of poor performance, or because other similar companies are stealing the limelight. But even these poorly performing companies might issue sizeable dividends. However, income investors are not banking on a tremendous price increase that will yield some sweet capital gains.
Overall, value stocks tend to be issued by stable companies that won't be going out of business anytime soon. Growth stocks, by contrast, tend to be issued by companies that have not yet withstood the test of time and are inherently riskier. Many experienced investors will build a portfolio from both growth stocks and value stocks, relying on the dividend payments and stability of the latter, and the potential capital gains of the former.
Buying Growth Stocks Now
Buying and selling stocks is a great way to profit from their capital appreciation, but you need to understand what you're buying. Growth stocks are great for investors who want to grow the value of their portfolio or ride a wave of potential success all the way to the shores of huge cash growth. These growth stocks are issued by companies that are in an aggressive phase of expansion, either because it's part of their business plan, or because they have a huge market share locked down with proprietary technology or a patent.
However, since many growth stocks are recently founded startups, it can be hard to predict where their stock price will go from one day to the next. That said, investors can mitigate their risk profile by balancing out their growth stock portfolio with some value stocks. The ratio of the two will depend on how much risk they can handle.