What is a Growth Stock and Should You Buy One?

What is a Growth Stock?
Investing in one is can significantly boost your portfolio’s returns

A growth stock is the share of a company that is expected to grow at a substantially higher rate than the growth of the market.

Typically, a growth stock does not pay a dividend. Why not you ask?

Simply because the company is reinvesting its earnings to accelerate its growth.

Investing in a growth stock is a speculative gamble hoping that a promising company will become a leader in its field.

The rewards lie in the potential capital gains when you eventually sell the shares and the possibility of getting an attractive yield on cost when the company decides to pay a dividend.

What is a Growth Stock?

Virtually any company can be considered a growth stock.

Usually, growth stocks trade at high Price-to-Earning ratios (P/E). While they have low present earnings, investors expect them to generate high revenues in the short to medium term. Thus, investors expect the P/E ratio to decrease as the company grows and becomes profitable.

It’s important to understand that investing in growth stocks is risky.

Generally, a growth company does not pay dividends and your investment will not generate an immediate income.

Thus, the only way you can make money is by selling your shares for more than you bought them. If the company fails to deliver on its promises, the share price will depreciate and you will eventually be forced to sell at a loss.

Always remember that most growth stocks are companies with promise. There is always a chance of failure.

Most growth stocks share similar characteristics.

First of all, growth stocks are usually innovative companies who tend to have unique offerings. Many growth companies have developed a cutting edge product, service or process that is protected by a patent. The patent gives them a competitive edge over their competitors. However, competitive edges don’t last forever. That is why growth companies need to reinvest every penny they earn back into R&D to keep innovating and growing long-term.

Secondly, growth companies often have a loyal fan base and/or a large market share of their respective industry. In the technology sector, innovative companies gain market share by offering new services. When competitors emerge, the company that attracts and keeps the most customers is usually the one who becomes the dominant growth stock.

Small-cap stocks are often considered growth stocks but large-cap stocks can also be considered growth stocks.

Growth Stock Examples

  • Apple (Nasdaq: AAPL)

Despite being the largest publicly traded company in the world, Apple is still technically considered a growth stock. At writing, the company boasts a Market Cap of $2.41 trillion dollars.

How can such an established company still be considered a growth stock?

For one reason: growth.

Investors are simple people: they want to invest in companies that are expected to grow at a higher rate than the overall market.

Indeed, if the company keeps earning more money, the stock will become more attractive and more people will buy it. The laws of supply and demand dictate that increased demand will increase prices. If the stock’s price keeps increasing, in 5-10 years the current price will look dirt cheap.

Look at Apple’s price chart: don’t you wish you invested 10 years ago?

What is a Growth Stock? AAPL is an excellent example of a perfect growth stock.

In 10 years, chances are you’ll probably wish you invested now.

  • Tesla (Nasdaq: TSLA)

Tesla is arguably one of the most controversial stocks in the world.

Some analysts claim it’s the most overvalued stock in history while others are adamant the company is a once-in-a-generation innovator who will revolutionize transportation. Price targets per share range from $150 (77% downside) to $3000 (361% upside).

What is a Growth Stock and Should You Buy One?

Either way, the current P/E ratio of 359 testifies to the cult stock’s status as the King of growth stocks.

After all, what else are investors buying other than the promise of market crushing returns over the next decade?

Although it will be difficult for Tesla to justify its valuation from a purely logical perspective, it is difficult to deny that it perfectly illustrates what is a growth stock.

Should You Invest in Growth Stocks?

As mentioned earlier, investing in growth stocks is usually risky.

However, the risk factor depends on what growth stock you’re buying.

For example, buying Apple is significantly less risky than buying Tesla.

Similarly, buying Tesla is probably less risky than buying the stock of an obscure biotech who claims to have found a cure for cancer.

Ultimately, it is your responsibility as a reasonable investor to perform your due diligence and invest in companies in line with your risk tolerance.

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