When it comes to investing, volatility and risk play an important role in investors’ decisions and, ultimately, their success. Some higher-risk investments offer investors the potential for faster growth. When combined with lower-risk securities, these growth investments may play a role in generating wealth in both the short- and long-term.
What is growth investing?
Put simply, growth investing is a strategy that centers around building an investor’s capital at an accelerated pace. It focuses on companies, markets, and assets that are expected to appreciate at an above-average rate.
This potential for accelerated returns can be appealing to many investors. However, it’s important to keep in mind that many of the securities that fall into the growth investing category—including growth stocks—are newer and can be volatile.
Characteristics of growth stocks
So, what is a growth stock, exactly? Growth stocks are the shares of companies that may not yet have a history of explosive success, but have the potential to far exceed the growth of others in their industry. Here are four characteristics of growth stocks:
- Growth stocks are typically tied to smaller, newer companies and may even be trading at a high price-to-earnings (P/E) ratio—and that’s assuming they even make money.
- Growth stocks appear to be high-priced investments at first glance, especially based on their earnings history. But analysts and investors have focused on these stocks because of their potential for impressive growth in the future.
- Growth companies often hold certain patents or cutting-edge technologies, or may show signs of being a groundbreaker in its field. This potential for innovation can be a driver of their high stock price.
- Growth stocks don’t generally pay dividends. Rather than distributing a portion of earnings to investors, growth stocks will plow any earnings back into the company to promote further growth. For this reason, most growth stock investors purchase these securities with the goal of building long-term capital, rather than eyeing them as a passive income stream.
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Common types of growth stocks
Growth stocks can arise in almost any industry. However, there are certain industries that tend to produce more growth stocks than others.
- Tech— The technology industry is constantly changing, fueling companies’ motivation to innovate. These companies may be involved in consumer or commercial technologies.
- Pharmaceuticals— Cutting edge medications and drugs have the potential to exponentially boost a company’s profits and lift its stock.
- Medical devices— Novel medical devices, tests and equipment can generate rapid profit growth, especially if new products are quickly adopted by the health-care industry.
- Consumer products— The consumer goods industry has provided investors with some of the most lucrative growth stocks of the past few decades.
Again, it’s important to note that growth stocks are not limited to these investment categories, and stocks that fall into these categories aren’t automatically considered growth stocks.
How to evaluate growth stocks
Because growth stocks generally include newer companies or those that have only recently begun trading publicly, they can be difficult to evaluate. In many cases, these companies trade for a higher price than their financial results would suggest. This can make them appear to be a poor investment choice—and indeed, some of them will be.
Although these investments come at a higher cost and have a greater chance for volatility, their potential for growth can be a fair tradeoff for investors.
Some factors to consider when evaluating growth stocks include (but are not limited to):
- Historical earnings growth
- Strong profit margins
- Projected earnings growth
- High returns on equity
Depending on the age of the company and its available history, some of this information may be limited. However, by looking at the individual company’s historical growth as well as the growth of its industry as a whole, you may be able to gauge whether it should be considered a growth stock. You can also analyze an investment based on the company’s profit margins over the past few years, and how those numbers compare to the industry average.
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