Growth stocks: What are they?

Definition

Growth stocks are shares of companies that are expected to experience above-average increases in revenue, earnings, and overall profitability compared to other companies in the market. These companies typically reinvest their earnings back into the business to fuel expansion and innovation rather than distributing large dividends to shareholders.

What are growth stocks?

Growth stocks are associated with companies that are projected to grow at a faster rate than the broader market or their industry peers. This growth can result from various factors, such as technological innovation, expanding market share, or strong consumer demand for their products or services. Investing in growth stocks usually requires a longer investment horizon, as the anticipated growth might take time to materialise. Investors who believe in the company’s growth prospects are often willing to hold onto the stock for several years.

Unlike value stocks, which often provide consistent dividends to shareholders, growth companies tend to reinvest their profits to fuel further expansion. This means growth stocks might offer lower or no dividends but aim to generate capital appreciation through stock price appreciation.

Due to their potential for above-average growth, growth stocks often trade at higher price-to-earnings (P/E) ratios compared to the overall market or value stocks. Investors are willing to pay a premium for the anticipated future earnings and growth prospects. However, growth stocks can be more volatile than other types of stocks due to the market’s high expectations for their future performance. While they have the potential for significant gains, they can also experience steep declines if they fail to meet growth expectations.

Many growth stocks are associated with sectors like technology, biotechnology, and innovative industries. These companies often drive advancements and disrupt traditional markets, which contributes to their growth potential.

Example of growth stocks

Imagine Tech Company XYZ, a relatively new but innovative technology firm that has been consistently developing cutting-edge products. Here are some characteristics that make it a growth stock:

High revenue growth: Over the past few years, Tech Company XYZ has experienced significant revenue growth, driven by the success of its new and innovative products.
Limited or no dividends: Rather than paying dividends to shareholders, Tech Company XYZ chooses to reinvest its profits back into research and development, expanding market reach, and scaling operations.
Investment in future technologies: The company allocates a substantial portion of its resources to developing emerging technologies, positioning itself as a market leader in different areas.
Stock price appreciation: The stock price of Tech Company XYZ has seen rapid appreciation over a relatively short period, reflecting the market’s confidence in its future growth potential.

Investors interested in growth stocks are often attracted to the potential for capital gains as the company expands and its stock price increases.