Did you know that the US stock market represents about 40% (~$44 trillion) of the global market equity cap? Investing in growth stocks has minted many millionaires over the years. But what are growth stocks, anyway?
There are numerous ways to get involved in stock investing. Read on to learn more about growth stocks.
What Is a Growth Stock?
On some level, most companies expect to grow; the difference tends to be the rate. However, when a company is anticipated to grow much faster than the average market growth, it's known as a growth stock.
Growth stocks usually don't pay dividends. Instead, these companies reinvest their profits into the company in an attempt to grow faster.
When someone invests in growth stocks, they're expecting to earn money by selling their shares for a higher price at a later date.
Growth Stock Example
For a good example of a growth stock, look no further than Amazon (AMZN). The company doesn't pay dividends on its stock, so investors won't make money based on Amazon's sales. Instead, Amazon reinvested its earnings, increasing its market share and thus its stock value by 65% from 2020 to 2021.
So, if you had invested $1,000 in the growth stock Amazon in 2020, and sold it in 2021 for $1,650 (+65%), you'd make a profit of $650. Not bad, right?
Keep in mind that a growth of 65% in one year on a name like Amazon doesn't happen often. It's more likely to happen due to unforeseen circumstances (such as the pandemic). Stocks can also fall sharply for unanticipated reasons.
Growth Stocks Explained
Growth stocks might show up in any industry or sector. They're known for trading at a high price-to-earnings ratio (P/E). A company's P/E ratio is its market value per share divided by its earnings per share.
Growth stocks typically don't pay dividends, or if they do, the dividend payout is usually low. Instead, growth companies reinvest their profits back into the business to finance expansion and fuel future growth.
Investors looking for growth stocks should carefully research a company before investing. Factors to consider include earnings growth, revenue growth, and margins. The top growth stocks generally have the same CANSLIM-quality fundamentals.
Growth stocks can be a good addition to any portfolio, but they come with risks. They're often more volatile than other types of stocks.
Commonalities Among Growth Stocks
There are a few things that a lot of growth stocks have in common. One is that the products they sell are usually unique. Perhaps they have a patent or innovation that other companies don't.
In order to keep its lead among its competition, the company reinvests the profits it makes into developing new products or services. Since these companies are known for innovation, they usually have loyal customers and a large piece of their market share.
The healthcare, tech, and e-commerce industries are examples of where you can find a lot of growth stocks. Companies like Amazon, Facebook, and Google are all growth stocks.
These companies tend to have high valuations, which means their stock price is expensive relative to their earnings and revenue. But investors are willing to pay a premium for these companies because they have the potential to generate a lot of growth in the future.
What Is Market Share?
A company's market share is the percentage of the total market that it controls. For example, if a company has a 20% market share, that means it has 20% of the total market for its products or services.
The market share is important because it gives investors an idea of how much of the market a company controls. Companies with a large market share usually have an easier time generating growth because they have a larger audience and they can use their market share to generate growth by acquiring other smaller companies that are in the same industry.
How Do You Know If a Company Is a Growth Stock?
The definition of growth, in business terms, is that the company has room for capital appreciation (increase in value). These are often smaller companies, newer companies, or companies in known growth sectors like software.
Sometimes growth stocks have negative earnings, which can be confusing for people new to stock investing. These are some of the highest P/E stocks you'll find. Even though the company might not be posting earnings yet, they're expected to, which is why they're a growth stock.
A company's earnings growth is what usually fuels a rise in the stock price, so this is what you want to focus on when researching a potential growth stock. Things like sales growth, earnings per share (EPS) growth, and return on equity (ROE) are all important measures to look at.
How Do You Spot a Growth Stock?
Spotting a growth stock requires a combination of technical analysis and fundamental analysis.
Technical analysis is the study of stock price movement. This technique can be used to identify price patterns and make predictions about where the stock is headed next. Fundamental analysis, on the other hand, looks at the financial health of the company and its ability to grow.
Again, if you are looking for guidelines to follow on the fundamental side of this, we recommend reading about CANSLIM, which is a framework designed specifically for selecting growth stocks.
On the Technical analysis side of things, you look for certain characteristics that play out over and over again. These could be candlestick patterns such as the bullish engulfing pattern, or hammer candlestick, and chart patterns such as the cup and handle pattern, or the high-tight flag.
Growth Stocks vs. Value Stocks
Generally speaking, value stocks have a lower P/E and pay a dividend. Growth stocks have a higher P/E and don’t pay a dividend. Growth stocks don’t usually pay dividends because they reinvest their profits to grow the company faster.
Value stocks typically pay dividends because they are not growing as quickly and need to return some of their profits to shareholders to keep them happy.
The P/E of a growth stock is usually higher than that of a value stock because investors are willing to pay more for the company’s future growth potential.
TraderLion focuses on growth stocks because they tend to move faster and provide better returns. Growth stocks tend to be more innovative companies and by reinvesting their profits back into the business to fuel growth, they grow much faster than needing to provide a dividend every month or quarter. Value stocks, while they may provide a steadier return, don’t have the same upside potential as growth stocks.
For traders looking to capitalize on such rapid growth, understanding the Volatility Contraction Pattern, a powerful trading strategy for identifying stock breakouts, becomes crucial. This approach helps in catching breakouts at the right moment while effectively managing risks.
Putting It All Together
Hopefully, this article answered your question regarding what are growth stocks. Growth stocks are companies that are expected to grow faster than the majority of stocks and focus on reinvesting their profits to fuel that growth. When investing in growth stocks, valuations are mostly irrelevant as they will always be trading at a premium due to investors' pricing in their future growth.
Growth stocks over the long term have outperformed the market significantly. The best way to think about growth stocks is that they are like a compounding machine, the more reinvested profits, the higher the growth rate and stock price.