If you’re an investor looking for stock in promising companies such as Netflix or BioTech start-ups, you will likely have heard about the concept of Growth Stocks. These stocks have a higher anticipated growth rate than the market average and are hence valued highly by investors looking towards possible capital gains.
In this article, we will be exploring the concept of Growth Stocks in detail; not only that, but we will also look at the distinct characteristics of Growth Stocks and the possible benefits of rooting on strategies that prioritize these stocks. So, without further ado, let us begin.
Definition of Growth Stocks
Taking Netflix as an example, we can observe how the unique business model of such an online streaming service helped establish a strong consumer base. Such a base allows optimism within investors who follow the growth investing strategy. They would invest in a technologically and societally unique company such as Netflix since they anticipate higher growth rates from it than the market average.
At times, this could mean that the stock market overvalues the stock, creating a high Price-to-(current)-Earnings (P/E) ratio. However, such an overvaluation is considered temporary since the growth stock is expected to surpass its existing valuation through increased on-the-ground earnings and revenues.
Indeed, investors who look towards Growth Stocks as a viable investment technique often prioritize the capital gains that will ensue when they sell their shares. A unique characteristic that arises from the concept of a growth stock is that such stocks do not pay dividends. Why is this so, you may ask? Well, the answer lies in the fact that growth stocks exist for companies whose revenues are increasing more quickly than those value companies which we discussed in a prior article.
Such circumstances force the companies to reinvest their earnings into the company’s long-term wealth-building projects, such as research and development, rather than prioritizing distributing current income to shareholders. When a company wishes to utilize its earnings to accelerate short-term growth, income to shareholders becomes relatively unimportant. Since the shareholder can only profit through capital gains when they sell their shares, they take on great risk if the company doesn’t reflect the enthusiastic growth rate projected for it.
Characteristics of Growth Stocks
We’ve looked at the definition of a Growth Stocks and touched briefly on its properties. In this section of the article, we will delve deeper into the various characteristics of a Growth Stock, making it easier for potential investors to spot one when they see it:
Competitive Advantage and Higher Growth Rate
The most significant property of a Growth Stock is that it displays relatively higher revenue changes than the market average. This means that investors are generally optimistic about the company’s future, which issues these stocks, and the stocks are prone to market swings. Why is this? This is mainly due to the company having a competitive edge in the industry. This could range from having a unique product line to introducing a new service that revolutionized an industry.
Consumer loyalty can be created through these unique services, making a company much more sustainable and delivering on its promises. Such occurrences are often limited to small-cap companies, and companies that have this advantage may utilize patents to capture a significant market share. This allows them to achieve higher earnings than average and allows for long-term growth.
No Dividends and Capital Gains
Growth stocks usually provide no income to shareholders in the form of dividends. Companies that issue these stocks are looking to utilize all their earnings and revenues for their company goals and developments. For rising technological industries, earnings are used not to prioritize shareholder profits but to accomplish innovation goals.
For investors who follow this investing strategy, the long-run outlook then consists of high capital gains. What makes such a scenario possible is that the company may grow by an unprecedented amount in the future, raising the value of the stock and allowing investors to profit from their trust in the company’s outlook. Of course, this would enhance the revenue-generating quality of the stock in the long run.
High-Level Risks
The downside of the lack of dividends is the high level of risk incurred by the investor. Of course, such a concept is a necessary consequence of the entire idea of investing in the first place.
However, it cannot be denied that it takes on a completely different outlook regarding growth stocks. Investors are relying on the long-term growth of the company in order to make money through capital gains.
In some scenarios, the company does not deliver upon the promises of growth and long-term revenue generation. This may be because the significance of the company’s service was exaggerated by social media or because of the external influence of unpredictable events such as the Global COVID Pandemic.
Such a reality makes the risk factor associated with growth stocks exceptionally high, even if the probability of a company not delivering is extremely low. What is required of investors is to be extremely prudent in their analysis of the underlying mechanisms of the company which has issued the growth stock. For private wealth management firms such as RVW Wealth, such care is exceptionally significant since customer security is of the utmost importance.
Difference between Value Stock and Growth Stock
We have discussed the fundamental basics of what a Growth Stock is and its characteristics. In this section of the article, we will be differentiating a Growth Stock from what has generally considered it’s the extreme opposite: Value Stocks.
Value Stocks are essentially the kind of stocks that are undervalued as a result of inefficient information portrayed by the market. This makes their stock value potentially relatively low as compared to the intrinsic worth of the company, when viewed objectively from its earnings and revenues.
No Dividend vs. Stable Dividend
We’ve noted that dividend payments are not typical with Growth Stocks. In fact, they may be bypassed altogether, and investors who then rely on Growth Stocks usually count on their long-term capital gains. This is because the stocks of Growth companies reinvest their earnings into accelerated growth.
Additionally, since companies which issue Growth Stocks are usually small-cap, payment handouts are relatively harder since the company has not yet established itself in a stable sense.
On the other hand, Value Stocks have a very low Price-to-Earning (P/E) ratio. This shows that they are undervalued relative to their earning potentials. Since investors usually invest in stable companies with a long history of stable financial performances when it comes to value stocks, they can expect stable dividend handouts.
Undervalued vs. Overvalued
The primary reason for why the above is the case lies with this basic difference. A Value Stock is undervalued, given less media attention, and is perceived to not be especially poised for growth in the long term.
On the other hand, a Growth Stock usually exists for a company that has made a breakthrough that has captured media attention, shooting up its current value. Investors anticipate that the company will do better than most others in the industry, and this makes the stock overvalued in the short term. The expectation with the latter is that the company will eventually realize its potential in the future through multiplied earnings.
With the former, investors expect reliable dividends and long-term advantages owing to historical legacy and security. Value investors are also saved from market volatilities, and therefore generally carry fewer risks than Growth investors.
A Growth Stock investor, however, has the benefit of much larger long-term returns and a much more exciting investing prospect. They are both two sides of the same coin, and hence a stock portfolio should have a healthy balance between these two types of stocks.
Benefits of Growth Stocks
When a start-up company or large-scale innovation gets the recognition it deserves, everyone wins. In the case of Growth Stocks, this is literal. These stocks are an essential part of growth for companies who wish to reinvest their profits and earnings into development and innovation.
Not only do they provide a way to enhance revenues and brand name, but they also cause the company’s shares to increase in value, benefiting the investor. In short, Growth Stocks are a sort of incentive for the company to keep innovating and increasing its real worthwhile, providing investors with the opportunity to bet on long-term and sustained success. If the company succeeds, the investor can sell their shares and make tremendous amounts of profit.
For investors, Growth Stocks are a perfect opportunity to invest in stocks that show great momentum and sustainable potential. If the investor is able to capitalize on companies that show the momentum of large-scale growth, they can make huge profits once the stock values rise due to increased growth.
Of course, stable companies such as Walmart, which is considered to be a Value stock, were also on the cusp of success and growth at one point in time. Such companies, which can achieve the same level of dominance as well-established institutions, can be identified by investors carrying major long-term benefits. Additionally, it allows investors to look for companies that show sustained growth within stagnant economies.
It allows them to look outside their comfort zone, betting on the growth of organizations and start-ups, which their analysis shows can revolutionize the world. It helps those companies to have the incentive, branding, and financing to be able to make those hopes possible. With that, it also helps the investor to benefit from this growth through momentous profits in the long run.
Conclusion
This leads us to our conclusion. Despite being risk-prone and exceptionally prone to volatility, Growth Stocks are an essential part of the financing world. Investors who follow the Growth Investing strategy bet on the rapid growth of particular companies, knowing the risks that the overvaluation can entail.
They wait patiently for the sustained growth of the said company, which reinvests its earnings into development and innovation. Such growth allows the company to exceed its initial overvaluation, providing massive capital gains for investors who capitalized on its momentum. It carries risks, and it carries equally high rewards as well. Such stocks should not be overlooked by investors since they are pivotal for future growth and innovation.
September 10, 2021
RVW Wealth