What Is Growth Investing?
Growth investing is a strategy that focuses on capital appreciation and targets companies that are expected to grow faster than their peers. It aims for big returns but also comes with high risk if these companies don’t perform as expected. Investors should consider factors like a company’s revenue growth, innovation, market potential, and leadership to determine their future growth potential. It is contrasted with value investing, which looks for strong companies that are undervalued. Notable investors like Thomas Rowe Price, Jr., Philip Fisher, and Peter Lynch helped shape growth investing by stressing long-term growth.
Key Takeaways
- Growth investing targets companies expected to grow faster than their industry, often resulting in higher potential returns but also increased risk.
- Growth stocks are attractive for their potential capital appreciation, focusing on rising stock prices over dividends.
- Successful growth investors evaluate historical and projected earnings, profit margins, return on equity, and stock performance.
- Influential figures in growth investing include Thomas Rowe Price, Jr., Philip Fisher, and Peter Lynch, known for pioneering growth and hybrid strategies.
Understanding Key Concepts in Growth Investing
Growth investors often look for opportunities in industries or markets that are rapidly expanding with new technologies and services. They aim to profit from capital appreciation, or gains made by selling their stock, rather than receiving dividends. Most growth companies reinvest profits into their business instead of paying dividends.
These companies tend to be small, young companies with excellent potential. They may also be companies that have just started trading publicly. The idea is that as the company grows in earnings or revenues, its stock prices will rise. Growth stocks may therefore trade at a high price/earnings (P/E) ratio. They may not have earnings at the present moment but are expected to in the future. This is because they may hold patents or have access to technologies that put them ahead of others in their industry. In order to stay ahead of competitors, they reinvest profits to develop even newer technologies, and they seek to secure patents as a way to ensure longer-term growth.
Because investors seek to maximize their capital gains, growth investing is also known as a capital growth strategy or a capital appreciation strategy.
Evaluating a Company’s Growth Potential
Growth investors look 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 use specific methods or criteria to analyze potential investments, but these must consider a company’s unique situation, including its past industry performance and financial history.
Growth investors typically consider five main factors when choosing companies for capital appreciation. These include:
Strong Historical Earnings Growth
Companies should show a track record of strong earnings growth over the previous five to 10 years. The minimum earnings per share (EPS) growth depends on the size of the company: for example, you might look for growth of at least 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. The basic idea is that if the company has displayed good growth in the recent past, it’s likely to continue doing so moving forward.
Strong Forward Earnings Growth
An 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 grow 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 dividing by sales. It’s an important metric to consider because a company can have fantastic growth in sales with poor gains in earnings—which could indicate management is not controlling costs and revenues. A company is considered a good growth candidate if it surpasses its past five-year average and industry pretax profit margins.
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 dividing net income by shareholder equity. A good rule of thumb is to compare a company’s present ROE to the five-year average ROE of the company and the industry. A stable or rising ROE suggests that management efficiently generates returns from shareholders’ investments and runs the business well.
Strong Stock Performance
In general, if a stock cannot realistically double in five years, it’s probably not a growth stock. Keep in mind, 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’s certainly feasible for young companies in rapidly expanding industries.
Important
You can find growth stocks trading on any exchange and in any industrial sector—but you’ll usually find them in the fastest-growing industries.
Key Differences Between Growth and 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 do consider a company’s fundamental worth—tend to ignore standard indicators that might show the stock to be overvalued.
While value investors look for stocks that are trading for less than their intrinsic value today—bargain-hunting so to speak—growth investors focus on the future potential of a company, with much less emphasis on the present stock price. Unlike value investors, growth investors may buy stock in companies that are trading higher than their intrinsic value with the assumption that the intrinsic value will grow and ultimately exceed current valuations.
Those interested in learning more about the growth investing, value investing, and other financial topics may want to consider enrolling in one of the best investing courses currently available.
Notable Leaders in Growth Investing
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 first mutual fund to be offered by his advisory firm, T. Rowe Price Associates. This flagship fund averaged 15% growth annually for 22 years. Today, T. Rowe Price Group is one of the largest financial services firms in the world.
Philip Fisher also 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 many he authored. Emphasizing the importance of research, especially through networking, it remains one of the most popular growth investing primers today.
Peter Lynch, who managed the famous Magellan Fund at Fidelity Investments, created the “growth at a reasonable price” (GARP) strategy by mixing growth and value investing.
Case Study: Amazon As a Leading 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 some time. As of Q1 2021, Amazon ranks in the top three U.S. stocks in terms of its market capitalization.
Amazon’s stock often trades at a high price-to-earnings (P/E) ratio. From 2019 to early 2020, the P/E remained above 70, then decreased to about 60 in 2021. Despite its size, Amazon’s projected EPS growth for the next five years is around 30% annually.
When a company is expected to grow, investors remain willing to invest (even at a high P/E ratio). This is because several years down the road, the current stock price may look cheap in hindsight. The risk is that growth doesn’t continue as expected. Investors have paid a high price expecting one thing, and not getting it. In such cases, a growth stock’s price can fall dramatically.
Final Thoughts on Growth Investing
Growth investing can offer high rewards by targeting companies expected to grow faster than their industry, but the tradeoff is higher risk, especially with newer or untested businesses. Unlike value investors, who look for undervalued stocks based on current fundamentals, growth investors focus on future potential and are willing to pay a premium for it.
They often weigh factors like earnings growth, profit margins, return on equity, and past stock performance when making decisions.
Well-known figures such as Thomas Rowe Price, Jr., Philip Fisher, and Peter Lynch have shown how effective this strategy can be. However, it’s not suitable for everyone. Investors need to consider their risk tolerance and long-term goals before choosing growth investing.
