When an investor considers buying a growth stock, they aren’t shopping for a bargain. In fact, they may pay a premium for shares they expect to beat the market. Inherent in growth investing is the assumption that the best is yet to come, and that the need for income today isn’t very important. The anticipated payoff is that a rising share price will yield capital gains down the road that will be greater than the returns from any dividends paid today.
Here’s a look at what growth stocks are, how they can benefit investors, and how these investments behave in both the short and long term.
Growth stocks definition
A growth stock is an investment that is expected to increase in value at a rate that tops the market average. These also tend to be relatively expensive based on common valuation measures.
Successful growth stocks manage to generate higher-than-average returns over an extended period of time, rather than being an overnight success. In order to accomplish this, growth companies are often those that:
- Have created an innovative product or service
- Are entering or developing a new market or niche
- Develop or spearhead a unique industry altogether
Another way to look at growth stocks, says Titan strategist Myles Udland: “It’s a business that is growing very quickly, that is moving into a large market and that is taking share in that market either from incumbents or as that market grows.”
What are the main characteristics of growth stocks?
While there’s no guarantee that a particular stock will indeed surpass broader market growth, there are a couple of key features to keep in mind when trying to identify growth stocks.
- They’re expensive. At first glance, a growth stock may appear expensive, based on its share price. That’s because investors are counting on its future potential, and not so much its performance in the past or even the present. Typically, a growth stock will already be trading at a high price-to-earnings (P/E) ratio, exceeding the market average. For that reason, growth stocks usually are not bargains or undervalued. Another feature: Because of a rising share price, the company’s market capitalization may grow at a faster rate than the rest of the market. This share price increase may also be supported by growth in the earnings per share that also exceeds the market average or growth in the rest of the industry that the company is in.
- They (typically) don’t pay dividends. These companies tend to reinvest their earnings back into the business, rather than offering passive income to shareholders through quarterly payouts. Investing in future growth is one of the main appeals for growth investors. By plowing current earnings back into the business, the company is telling the market that it has confidence in the odds of success.
- They (hopefully) generate capital gains. Because growth stocks don’t often pay dividends, most growth investors purchase these stocks with their eye on capital gains down the line. If and when the stock appreciates, the investor will recognize the value of that growth after selling the shares.
- They’re risky. There is no sure-fire way to truly identify a growth stock, except in hindsight. The defining feature of growth stocks is their future potential, not necessarily their results today. They also have the potential to be a bust. When an investor is paying top dollar for shares in a company that they expect to outpace the market, a failure to meet those expectations can be detrimental.
Examples of growth stocks
Online retailer Amazon (AMZN) is one of the best known growth stocks. It has reinvested earnings back into the company rather than pay dividends to investors. Indeed, for many years the company intentionally operated a loss while it spent heavily on expansion. Meanwhile, Amazon’s stock price rose from about $190 at the start of 2012 to about $3,350 at the start of 2022—a gain of more than 1,700%.
Streaming service Netflix (NFLX) is another example. Trading for less than $20 a share in 2012, the company rose to almost $700 by the end of 2021. That’s a gain of roughly 3,000% in just a decade’s time.
Growth and value stocks: Key differences
Growth and value stocks have their place in a diversified investment portfolio. Many investors choose a blend of the two types of stocks as part of a comprehensive investment strategy.
Here are some of the key differences and attributes of growth and value stocks.
Value stocks are shares of companies that are considered undervalued, and for certain reasons trade at a discount to the value of the business’s assets. Investors buy these stocks expecting that when the market re-evaluates and recognizes the worth of the assets, the stock price will outperform.
Because value stocks are purchased below the company’s intrinsic value, investors have a bit more wiggle room in terms of returns. For this reason, they are typically viewed as less risky than growth stocks. Value stock companies also may or may not offer dividends to investors. But there is a risk that if the company experiences setbacks, any dividend may be reduced or even eliminated.
Growth stocks, on the other hand, are purchased at a P/E ratio that’s usually higher than the market average, and they are rarely viewed as bargains. In some cases, a growth stock won’t even have a positive P/E if it doesn't have net income, which was the case for many years with Amazon. What’s more, if the expected above-average growth doesn’t come to fruition, investors may sour on the company and the shares might plunge.
Part of the reason growth stocks are susceptible to big reversals is that they generally don't offer passive cash flow for investors, which can provide a floor to share prices.
The bottom line
Growth stocks are one option for investors looking to buy into companies where the future is more important than the present. Growth companies are those that are expected to have above-average growth compared to the broader market.
Growth stocks often command higher prices relative to many other stocks, and they don’t typically pay dividends. If those above-average gains are recognized, however, they have the potential to offer much bigger rewards for their investors.