A growth stock is a share in a company that is expected to grow at a rate significantly above the market average. Typically, these stocks do not pay dividends, as the companies prefer to reinvest any earnings to accelerate short-term growth. Investors aim to profit through capital gains when they eventually sell their shares.
Key Takeaways
- Growth stocks are companies expected to grow sales and earnings faster than market averages.
- They often trade at high P/E ratios, but these valuations may be justified if the company continues its rapid growth, driving share price up.
- If growth expectations are not met, these stocks can decline dramatically.
- Growth stocks typically don’t pay dividends.
- They contrast with value stocks.
Understanding Growth Stocks
Growth stocks appear in any sector or industry and usually trade at high price-to-earnings (P/E) ratios. They might not generate current earnings but are expected to in the future.
Investing in growth stocks can be risky. Since they usually don’t offer dividends, investors earn money only when they sell shares. If the companies underperform, investors face losses.
Characteristics of Growth Stocks
Here are common traits:
- High Innovation: Growth companies often have unique products or patents, keeping them ahead of competitors by reinvesting in newer technologies.
- Market Share: They might capture significant market share due to first-mover advantage or better services/products.
- Customer Loyalty: High innovation often translates to loyal customers.
Growth stocks are frequently found in rapidly growing industries and on innovative exchanges like the Nasdaq.
Growth Stocks vs. Value Stocks
Growth stocks differ significantly from value stocks. Investors expect growth stocks to generate substantial capital gains due to strong growth prospects. This expectation often results in high P/E ratios, which may appear overvalued.
On the other hand, value stocks are often underrated, with the potential to gain market value over time. These stocks usually pay dividends and have low P/E ratios. Some investors diversify their portfolios with both stock types, while others specialize by focusing on value or growth.
Traits of Value Stocks
- Might be underpriced due to negative publicity or poor earnings reports.
- Often have strong dividend-payout histories.
- Tend to be older companies, reliable but not highly innovative.
Example of a Growth Stock: Amazon Inc.
Amazon Inc. (AMZN) is a quintessential growth stock example. In 2023, it’s among the largest global companies, ranking fourth in market capitalization as of December 2023. Amazon’s stock has historically traded at high P/E ratios, ranging from 51 to 245 between September 2021 and December 2023. Yet, growth estimates for 2024 exceed 33%.
Investors continue investing even at high P/E ratios due to growth expectations. The risk lies in growth potentially falling short of expectations, causing dramatic stock price declines.
Identifying Growth Stocks
Growth stocks usually have substantial room for capital appreciation. They often belong to newer, smaller-cap companies or growth sectors like technology or biotech. These stocks usually have low or negative earnings, presenting high P/E ratios as their hallmark.
Are Growth Stocks Risky?
As with all investments, growth stocks bring a trade-off between risk and return. They promise substantial future returns, but they come with high risks. The primary risk is that anticipated growth fails to materialize, leading to stock price drops if investors paid a high price based on unmet expectations.
Hypothetical Growth Stock Example
Consider a biotech startup developing a promising new cancer treatment in early-stage clinical trials. If successful, the company could see huge profits, attracting significant market valuation. However, failures in the trials can lead to substantial investment losses.
Distinguishing Growth from Value Stocks
Value stocks are typically undervalued and aim to offer superior returns as their stock prices close the fundamental gap. Unlike growth stocks, value stocks often boast higher-than-average dividend yields and strong fundamentals, featuring low P/E and price-to-book (P/B) ratios.
The Bottom Line
Investing in growth stocks is a bet on substantial future capital gains. Unlike value stocks, selected for strong current fundamentals, growth stocks appeal for their high potential despite low current earnings. However, they bring higher risks; if expected growth doesn’t occur, investors may face significant losses.
Related Terms: Capital Gains, Price-to-Earnings Ratio, Dividends, Market Share, Small-Cap Stocks.
References
- Nasdaq. “Stocks”.
- Companies Market Cap. “Largest American Companies by Market Capitalization”.
- Macrotrends. “Amazon PE Ratio 2010–2023, AMZN”.
- Yahoo! Finance. “Amazon.com, Inc. (AMZN)”.
