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Growth Stocks – What are they, Pros & Cons, FAQs

  • Marisha Bhatt
  • Nov 10 2021
  • 9 minutes
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There are many types of investment options that are available to investors in the market today. While mutual funds are a relatively safer option for any class of investors, stocks are also a good option, especially for aggressive and seasoned investors. There are two main categories of stocks that are analyzed and invested by the investors namely, growth stocks and value stocks. 

Let us understand the meaning of growth stocks and relevant details for the same. 

What are growth stocks?

Growth stocks are the stocks that have the highest growth potential in comparison to the other stocks in that industry or segment of companies. When the economy and market are on a boom, growth stocks provide maximum returns on investment. These stocks are high-growth-oriented companies that usually earn high profits from their business. These profits are not usually distributed to the shareholders but are reinvested in the business to increase the profitability of the business and ultimately the EPS (Earnings Per Share) of the shares. 

What are the features of growth stocks?

Growth stocks have quite particular characteristics that make them very attractive investment options for investors. Some of the main features of growth stocks are mentioned below.

Return on investment 

The returns on investment in growth stocks are the highest as compared to similar stocks in the industry. These stocks do not provide high dividends to the investors. The profits are usually reinvested in the business to increase its profitability. Also, the return on investment in growth stocks is not too high in the short term. The growth rate of these stocks is quite higher than the average market growth rate. The capital gains on these growth stocks are quite substantial in the long term on account of the high growth rate of the business and ultimately their stocks. 

Risk of investment

The returns on investment in growth stocks are high and the risk of such investment is also quite high. The risk of investment is especially high in short-term investments. Growth stocks fail in rare cases and hence the risk is lowered significantly in the long run. In the short term, the returns in the form of capital gains are not significant and the dividends are usually not declared by the company. Hence the risk of investment in the short term is significantly higher in the case of growth stocks as compared to other stocks or investment options for a similar duration. 

Growth rate

The growth stocks have the highest rate of growth among all types of stocks available in the market. Investment in these stocks yields the highest rate of return in the long term. The growth rate is nominal in the short term but is usually higher than the market average.

Advantage over competitors 

Growth stocks usually have a unique business model that provides them some advantage over their competitors. This advantage yields increased profitability eventually leading to higher growth. This advantage over competitors is quite essential for the business to grow as well as maintain its high growth rate and eventually become a market leader.

Loyal customer base

Growth stocks enjoy the benefit of a loyal customer base on account of their competitive advantage. The increasing business opportunities and the USP of the business of growth stocks allow the company to enjoy a loyal customer base that prefers them over their competition.

What are the pros and cons of growth stocks?

Growth stocks have many advantages and disadvantages over other stocks in the same industry or segment. Let us discuss both these aspects of growth stocks.

Advantages of growth stocks

Some of the common advantages of growth stocks are mentioned below.

  1. Growth stocks provide a high rate of return as a long-term investment option.
  2. These stocks are usually potential market leaders and hence post constant returns that lead to increased earnings for the shareholders.
  3. Growth stocks usually do not always require a huge capital investment and the investors also have the option to gradually increase their exposure to such stocks as and when they get more funds to invest.

Disadvantages of growth stocks

Some of the most common disadvantages of growth stocks are highlighted below.

  1. Growth stocks are among the high-risk stocks and hence may not be ideal for investors with a low-risk appetite.
  2. There is virtually no return or negligible return from growth stocks in the short term.

What are a few differences between growth stocks and value stocks?

There are various categories based on which stocks can be classified. However, the broad classification for stocks is usually growth stocks and value stocks. Given below are a few basic points of distinction between growth stocks and value stocks.

Category  Growth stocks Value stocks
Meaning  Growth stocks are the high-performing stocks that are usually market leaders. Value stocks on the other hand are stocks that are usually undervalued as per market average 
Investor perception Growth stocks are perceived by investors to be of high sales and profit-oriented companies  Value stocks have strong fundamentals as well as more or less stable growth avenues.
Fundamental ratios Growth stocks have a high PE ratio and a high PB ratio Value stocks have a relatively lower PE ratio and PB ratio as compared to industry averages.
Risk The risk in growth stocks is usually higher as they are highly volatile stocks Value stocks are relatively safer stocks as they are less expensive as well as less volatile.
Dividends Growth stocks usually do not pay high dividends and prefer to reinvest the profits in the business to further increase the growth prospects of the company.   Value stocks pay high dividends and have higher dividend yields as compared to growth stocks.

What are a few tips for selecting the best growth stocks?

The market is flooded with many options for stock investments and often makes it difficult for an average investor to distinguish between good quality growth stocks and the rest. Given below are a few pointers that can help them choose better growth stocks and increase their wealth in the long term.

Small-cap or mid-cap stocks

Companies with high growth potential are usually from the small-cap or mid-cap segment. These stocks have sound growth projections for the company and have a unique product or service that provides them with a niche in the market.

Higher return on equity

The return on equity of growth stocks is usually higher than the market average. Growth stocks prefer to reinvest the profits earned back into the company to generate higher profitability. This eventually increases the return on equity for the investors. If a company is not able to provide a higher return on equity despite reinvesting the profits earned, such a company is better off distributing the profits to its shareholders in the form of dividends.

Dividend payout ratio

The key feature of a growth company is the reinvestment of profits into the business to increase the profitability of the business. In most cases, growth stocks have the maximum dividend payout ratio of up to 50%. 

Management of the company

The management of the company is another important factor that has to be considered while picking growth stocks. The management of the company has to be capable of navigating the company finances to steer them in the best way to generate constant profitability and provide better returns on the growth stocks.

Tracking of the performance of the company for evidence of growth potential

The growth potential of a company is dependent on many factors that have to be constantly monitored. The evidence needed should be tangible and supported by factual figures and documentation. This is necessary for the investors to avoid any misguided decisions made on account of the window dressing of financial statements by the management of the company.

Strong financial statements of the company

The financial statements of the company have to be quite strong to project the financial stability of the business. The classic features of strong financial statements of a business are,

  1. Strong cash position so the working capital of the company is not affected
  2. Comfortable debt position which does not endanger the existence of the company
  3. Strong assets and investments of the company that can back the future growth projections of the company. 

Conclusion

Growth stocks have the potential to increase the investor’s wealth exponentially as compared to many stable stocks and current industry giants. It is an excellent option to be included in any portfolio not only to balance it with stable investment options but also as a means to meet financial goals faster.  

FAQs

Are the financial ratios of growth stocks higher or lower than the industry average?

The financial ratios like PE ratio, PB ratio, are higher in the case of the growth stocks than the industry averages.

What is the primary source of wealth maximization for investors of growth stocks?

Companies considered as growth stocks usually do not usually declare any dividends and prefer to reinvest them in the business to increase its growth potential. Hence, the investors of growth stocks can maximize their wealth through capital gains arising in the long term.

Are growth stocks volatile than value stocks?

Yes. Growth stocks are considered to be more volatile than value stocks or stocks of bigger companies and industry stalwarts as they are considered to be more or less stable stocks that do not react much to market volatility.

What are the common factors to identify the growth stocks?

The common factors to identify growth stocks are the increased EPS as compared to industry average, higher PE ratio of the company as compared to its peers, constant increase in the sales and profits of the company on a year on year basis.

Who are the target investors for growth stocks?

The target investors for growth stocks are investors with relatively higher risk appetites and a long-term investment horizon.

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