Regardless of investment style, we as investors share a common goal of growing our wealth over time. Investing in growth stocks can be a great way to earn life-changing wealth in the stock market. The key, of course, is to know which growth stocks to buy — and when.
To help you get started, here is a handy guide to growth investing. With these tools and strategies, you’ll be able to position your portfolio for long-term success with growth stocks.
What is a growth stock?
Growth stocks are companies that increase their revenue and earnings faster than the average business in their industry or the market as a whole. Growth stocks usually pay smaller dividends or they do not pay dividends as the company typically reinvests retained earnings in capital projects.
Investors expect growth stocks to earn substantial capital gains as a result of strong growth in the underlying company.
Often a growth company has developed a new product, a breakthrough patent, overseas expansion or service that is gaining share in existing markets, entering new markets, or even creating entirely new industries.
Businesses that can grow faster than average for long periods tend to be rewarded by the market, delivering handsome returns to shareholders in the process. And the faster they grow, the bigger the returns can be.
Unlike value stocks, growth stocks tend to be more expensive than the average stock in terms of metrics like price-to-earnings(PE), price-to-sales, and price-to-free-cash-flow ratios. Yet despite their premium price tags, the best growth stocks can still deliver fortune-creating returns to investors as they fulfill their awesome growth potential.
How to find growth stocks?
To find great growth stocks, you’ll need to:
- Identify powerful long-term market trends and the companies best positioned to profit from them
- Narrow your list to businesses with strong competitive advantages
- Further, narrow your list to companies with large addressable markets
6 Characteristics of Good Growth Stocks
1. Find growth stocks with the help of PEG ratio
This ratio is calculated thus: PE ratio/growth rate, where PE stands for price-to-earnings ratio. The growth rate is the estimated future earnings rate.
The PE ratio is used by investors to understand a stock’s market value in comparison with its earnings. It acts as an indicator of a stock’s market valuation apart from the price investors are willing to shell out for the earnings of a company. A high PE ratio may be interpreted as high price of a stock vis-a-vis its earnings. It could mean that a stock is overvalued. On the flip side, a low PE ratio means the price of a stock is low vis-a-vis its earnings. However, stocks that have higher growth trade at larger multiples than stocks with lower future growth, so the PE ratio doesn’t indicate much about future growth prospects.
That’s the limitation of PE ratio: it only takes into account a company’s earnings at this point in time. It doesn’t account for the rate at which the company grows.
This is where PEG ratio comes into the picture. Reputed Wall Street investor and author Peter Lynch popularised the concept of this ratio. So, according to him, the PE ratio of a company that is fairly valued will be equal to the growth rate. This is how investors know that a growth stock has been valued fairly. If the PEG ratio is 1, it means the stock is fairly valued. If it’s below 1, it is undervalued and if it’s over 1, it’s overvalued. This is way forward on the question of how to find high growth stocks.
2. A Good Growth Market
For any sized company to grow, it is going to have to play in a market that’s poised for growth or is already in growth mode. If the industry is at the tail end of its growth trajectory, it isn’t considered a growth market. For example, today may not be the best time to invest in a Computer hardware vendor but it could be the right time to get in on a mobile app start-up or a cloud-services company.
In addition to operating in a high growth industry, the stock you choose has to have a commanding market share. You do not want to get stuck with the third or fourth player in an emerging growth market. Nor do you want a one-trick pony, which means investors should look for companies that will be able to sustain their competitive advantage. Is the company coming out with many innovative, successful products? Or does it continue to ride its first success? These are questions investors need to consider.
3. The Company Is a Trend-Setter
If you’re at home watching Netflix or having a latte at Starbucks, as a consumer, you’re already immersed in a trendsetting experience.
Netflix and Starbucks are good examples of growth companies that have established major trends largely on their own. Netflix invented the video streaming experience and Starbucks has immortalized the concept of chain-based gourmet coffee (as well as becoming a home office for millions of emerging freelance workers.)
Trends matter when it comes to vetting good growth companies and nobody is expecting you to accurately predict the next Netflix, Starbucks, or Amazon.com. But if you’re actively involved in a cultural trend yourself, the company behind that trend stands as a strong example of a growth stock with more room to grow.
4. The Company Is in a Valuable Niche
Does a company do one product and do it well? If so, it’s ensconced itself in a profitable niche and stands to make a lot of money over a long period.
Finding growth stocks in a great niche — companies that excel at one thing and are emerging from the pack in doing so — are companies that can turn a profit for years to come.
Any company that sells a product or service with a loyal customer base and that is pouring money into the research and development necessary to put a stranglehold on that niche is worth looking into as a potential growth stock opportunity.
5. A Record of Strong Growth in Sales
While the company’s niche, growth, industry, and market share of a stock all matter a lot, it’s important to also consider the sales of the company. You want a company that is seeing an acceleration in earnings and revenue growth for constructive quarters (rather than one that has had irregular or slowing growth).
The faster the growth rate, the higher the likelihood the stock will rise. After all, companies that are boosting sales and earnings are going to be attractive investments for investors.
6. Strong Leadership Team
Because growth companies are focused on increasing the profits and sales of the organization, the management team is going to matter a lot. Growing a company requires an innovative leadership team. Without it, growth won’t happen.
If you are a Growth Investor, looking for their next investment, will want to choose companies that have a leadership team with a good track record and a reputation for being innovative. Think of Steve Jobs, Bill Gates, Jeff Bezos and Elon Musk as innovative company founders.
Growth stocks are attractive to many investors because they are growing. But that doesn’t mean you should overpay for a growth stock either. Growth investors want to avoid those stocks that have a big run-up because of investor demand or because fundamentals have declined but the stock price hasn’t.
TOP 10 Growth Stocks for next 10 years
Dalal Street’s most active investors and fund managers see a rapid growth in the following stocks for the next 10 years.
Disclaimer: All investment strategies and investments involve the risk of loss. Nothing contained in this website should be construed as investment advice. Finvestable.com advises users to check with certified experts before taking any investment decisions.