A growth stock is a company that is expected to grow at a rate significantly higher than the average growth of the stock market and consequently, generates earnings more rapidly.
Growth stocks often look expensive, trading at a high P/E ratio, but such valuations could actually be cheap if the company continues to grow rapidly which will drive the share price up. Growth stocks typically don’t pay dividends, but investors may make huge profits in capital gains when invested for medium to long term.
Understanding growth stocks-
A Growth stock can be defined as a company that is growing at a very fast rate compared to its competitors and industry average. The growth is generally measured here in terms of their Revenue (Top Line) or Profits (Bottom Line), where these metrics can grow 3-5x or more within the last three to five years. However, many times the growth can also be considered in terms of how fast it is acquiring customers or how fast it is getting more market share in its industry.
Growth stocks generally trade at a high valuation and you won’t be surprised to see the valuation even up to 100x PE for these companies. The high valuation of these stocks is justified with the earnings as they grow very fast year after year. Typically, the growths of these companies are around can be over 15-20% per year, while the rest of the nifty 50 stocks grow at an average of 3-7% per year.
Example of a Growth Stock-
E – Commerce ltd. (Nykaa) is being considered a growth stock. In November 2021, its IPO was launched.
Nykaa stock has listed at a high price-to-earnings (P/E) ratio of about 1600.
Despite the company’s size, EPS is just 1.39.
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.
Characteristics of growth stocks-
- High growth rate-
As their name suggests, growth stocks tend to show a significantly higher growth rate than the average market growth rate. It implies that the stocks grow at faster pace than the average stock in the market.
- Zero dividend-
Growth stocks usually pay no dividend at all. It is because growth companies are growing at a very fast pace and hence typically want to reinvest their earnings back into the company to boost the revenue generating capacity of the business.