Growth Investing
What Is Growth Investing?
Growth investing is an investment style and strategy that is focused on increasing an investor's capital. Growth investors typically invest in growth stocks — that is, youthful or small companies whose earnings are expected to increase at an above-average rate compared to their industry sector or the overall market.
Growth investing is highly attractive to numerous investors because buying stock in emerging companies can provide impressive returns (as long as the companies are successful). However, such companies are untried, and in this manner often pose a genuinely high risk.
Growth investing might be contrasted with value investing. Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value.
Understanding Growth Investing
Growth investors typically search for investments in rapidly expanding industries (or even entire markets) where new technologies and services are being developed. Growth investors search for profits through capital appreciation — that is, the gains they'll achieve when they sell their stock (as opposed to dividends they receive while they own it). As a matter of fact, most growth-stock companies reinvest their earnings back into the business rather than paying a dividend to their shareholders.
These companies tend to be small, youthful companies with excellent potential. They may likewise be companies that have just started trading publicly. The idea is that the company will prosper and expand, and this growth in earnings or revenues will eventually translate into higher stock prices from now on. Growth stocks may therefore trade at a high price/earnings (P/E) ratio. They might not have earnings right now but rather are expected to from now on. This is because they might hold patents or have access to technologies that put them ahead of others in their industry. To remain ahead of competitors, they reinvest profits to develop even newer technologies, and they seek to secure patents as a method for ensuring longer-term growth.
Because investors seek to maximize their capital gains, growth investing is otherwise called a capital growth strategy or a capital appreciation strategy.
Evaluating a Company's Potential for Growth
Growth investors check out at a company's or a market's potential for growth. There is no absolute formula for evaluating this potential; it requires a degree of individual interpretation, based on objective and subjective factors, plus personal judgment. Growth investors might use certain methods or criteria as a framework for their analysis, yet these methods must be applied considering a company's particular situation: Specifically, its current position versus its past industry performance and historical financial performance.
In general, however, growth investors see five key factors when selecting companies that might provide capital appreciation. These include:
Strong Historical Earnings Growth
Companies ought to show a history of strong earnings growth over the previous five to 10 years. The base earnings per share (EPS) growth depends on the size of the company: for example, you could search for growth of no less than 5% for companies that are larger than $4 billion, 7% for companies in the $400 million to $4 billion range, and 12% for smaller companies under $400 million. That's what the fundamental idea is assuming the company has displayed great growth in the recent past, it's likely to continue doing so moving forward.
Strong Forward Earnings Growth
A earnings announcement is an official public statement of a company's profitability for a specific period — typically a quarter or a year. These announcements are made on specific dates during earnings season and are preceded by earnings estimates issued by equity analysts. It's these estimates that growth investors pay close attention to as they try to determine which companies are likely to develop at above-average rates compared to the industry.
Strong Profit Margins
A company's pretax profit margin is calculated by deducting all expenses from sales (except taxes) and partitioning by sales. It's an important metric to consider because a company can have phenomenal growth in sales with poor gains in earnings — which could indicate management isn't controlling costs and revenues. In general, on the off chance that a company exceeds its previous five-year average of pretax profit margins — as well as those of its industry — the company might be a decent growth candidate.
Strong Return on Equity (ROE)
A company's return on equity (ROE) measures its profitability by revealing how much profit a company generates with the money shareholders have invested. It's calculated by partitioning net income by shareholder equity. A decent rule of thumb is to compare a company's present ROE to the five-year average ROE of the company and the industry. Stable or increasing ROE indicates that management is working really hard generating returns from shareholders' investments and operating the business efficiently.
Strong Stock Performance
In general, on the off chance that a stock can't realistically double in five years, it's probably not a growth stock. Keep as a top priority, a stock's price would double in seven years with a growth rate of just 10%. To double in five years, the growth rate must be 15% — something that is certainly feasible for youthful companies in rapidly expanding industries.
You can find growth stocks trading on any exchange and in any industrial sector — yet you'll typically track down them in the fastest-developing industries.
Growth Investing versus Value Investing
Some consider growth investing and value investing to be diametrically opposed approaches. Value investors seek "value stocks" that trade below their intrinsic value or book value, whereas growth investors — while they truly do consider a company's fundamental worth — tend to ignore standard indicators that could demonstrate the stock to be overvalued.
While value investors search for stocks that are trading for less than their intrinsic value today — deal hunting so to speak — growth investors center around the future potential of a company, with substantially less emphasis on the present stock price. Unlike value investors, growth investors might buy stock in companies that are trading higher than their intrinsic value with the assumption that the intrinsic value will develop and ultimately exceed current valuations.
Those interested in learning more about the growth investing, value investing, and other financial topics might need to consider enrolling in one of the best investing courses currently available.
Some Growth Investing Gurus
One notable name among growth investors is Thomas Rowe Price, Jr., who is known as the father of growth investing. In 1950, Price set up the T. Rowe Price Growth Stock Fund, the principal mutual fund to be offered by his advisory firm, T. Rowe Price Associates. This flagship fund averaged 15% growth every year for a long time. Today, T. Rowe Price Group is one of the largest financial services firms in the world.
Philip Fisher likewise has a notable name in the growth investing field. He outlined his growth investment style in his 1958 book Common Stocks and Uncommon Profits, the first of numerous he authored. Emphasizing the importance of research, especially through networking, it remains one of the most popular growth investing primers today.
Peter Lynch, manager of Fidelity Investments' legendary Magellan Fund, pioneered a hybrid model of growth and value investing, which is presently generally referred to as "growth at a reasonable price" (GARP) strategy.
Example of a Growth Stock
Amazon Inc. (AMZN) has long been considered a growth stock. In 2021, it remains one of the largest companies in the world and has been for quite a while. As of Q1 2021, Amazon positions in the top three U.S. stocks in terms of its market capitalization.
Amazon's stock has historically traded at a high price to earnings (P/E) ratio. Between 2019 and early 2020, the stock's P/E has remained upwards of 70, moderating to around 60 out of 2021. Despite the company's size, earnings per share (EPS) growth estimates for the next five years actually hover near 30% per year.
When a company is expected to develop, investors remain able to invest (even at a high P/E ratio). This is because several years down the road the current stock price might look cheap in hindsight. The risk is that growth doesn't continue true to form. Investors have paid a high price expecting one thing, and not getting it. In such cases, a growth stock's price can fall decisively.
Highlights
- Growth investing is a stock-buying strategy that searches for companies that are expected to develop at an above-average rate compared to their industry or the broader market.
- Growth investors often shift focus over to five key factors when evaluating stocks: historical and future earnings growth; profit margins; returns on equity (ROE); and share price performance.
- Growth investors tend to lean toward smaller, younger companies poised to expand and increase profitability potential in the future.
