What Is Growth Investing?
Growth investing is an investment style and strategy that is focused on increasing an investor's capital. Growth investors typically invest in growth stocks—that is, young or small companies whose earnings are expected to increase at an above-average rate compared to their industry sector or the overall market.
Growth investing is highly attractive to many investors because buying stock in emerging companies can provide impressive returns (as long as the companies are successful). However, such companies are untried, and thus often pose a fairly high risk.
Growth investing may be contrasted with value investing. Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value.
key takeaways
- Growth investing is a stock-buying strategy that looks for companies that are expected to grow at an above-average rate compared to their industry or the broader market.
- Growth investors tend to favor smaller, younger companies poised to expand and increase profitability potential in the future.
- Growth investors often look to five key factors when evaluating stocks: historical and future earnings growth; profit margins; returns on equity (ROE); and share price performance.
Understanding Growth Investing
Growth investors typically look for investments in rapidly expanding industries (or even entire markets) where new technologies and services are being developed. Growth investors look for profits through capital appreciation—that is, the gains they'll achieve when they sell their stock (as opposed to dividends they receive while they own it). In fact, most growth-stock companies reinvest their earnings back into the business rather than paying a dividend to their shareholders.
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 the company will prosper and expand, and this growth in earnings or revenues will eventually translate into higher stock prices in the future. Growth stocks may therefore trade at a highprice/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.
Becauseinvestors 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 Potential for Growth
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 may use certain methods or criteria as a framework for their analysis, but these methods must be applied with a company's particular situation in mind: Specifically, its current position vis-a-vis its past industry performance and historical financial performance.
In general, though, growth investors look at five key factors when selecting companies that may provide 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. In general, if a company exceeds its previous five-year average of pretax profit margins—as well as those of its industry—the company may be a good growth candidate.
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. Stable or increasing ROE indicates that management is doing a good job generating returns from shareholders’ investments and operating the business efficiently.
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.
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.
Growth Investing vs. Value Investing
Some considergrowth investing and value investingto bediametrically opposed approaches. Value investors seek "value stocks" that trade below theirintrinsic 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.
Some Growth Investing Gurus
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, manager of Fidelity Investments' legendary Magellan Fund, pioneered a hybrid model of growth and value investing, whichis now commonly referred to as "growth at a reasonable price" (GARP) strategy.
Example of a 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 itsmarket capitalization.
Amazon's stock has historically traded at a high price to earnings (P/E) ratio. Between 2019 and early 2020, the stock's P/E has remained upwards of 70, moderating to around 60 in 2021. Despite the company's size,earnings per share(EPS) growth estimates for the next five years still hover near 30% per year.
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.
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Growth Investing
Growth investing is an investment style and strategy focused on increasing an investor's capital. It involves investing in growth stocks, which are young or small companies expected to experience above-average earnings growth compared to their industry sector or the overall market Growth investing is attractive to many investors because it can provide impressive returns, although it also carries a higher risk due to the untried nature of these companies.
Value Investing
Value investing is an investment strategy that involves selecting stocks that appear to be trading for less than their intrinsic or book value. Unlike growth investing, value investing focuses on the present value of a company and seeks to identify undervalued stocks.
Key Factors Considered by Growth Investors
When evaluating stocks for growth investing, investors often consider five key factors:
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Historical and Future Earnings Growth: Growth investors look for companies with a track record of strong earnings growth over the previous five to 10 years. The minimum earnings per share (EPS) growth required depends on the size of the company, with larger companies expected to have higher growth rates.
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Profit Margins: Growth investors analyze a company's pretax profit margin, which indicates how well the company controls costs and generates earnings. If a company exceeds its previous five-year average of pretax profit margins and those of its industry, it may be considered a good growth candidate.
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Return on Equity (ROE): ROE measures a company's profitability by revealing how much profit it generates with shareholders' investments. Growth investors compare a company's present ROE to its five-year average ROE and the industry average to assess its potential for growth.
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Share Price Performance: Growth investors look for stocks that have the potential to double in value within a specific timeframe, typically five years. Young companies in rapidly expanding industries are more likely to achieve this level of growth.
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Industry and Market Potential: Growth investors seek investments in rapidly expanding industries or markets where new technologies and services are being developed. They aim to profit from capital appreciation rather than dividends, as growth stocks often reinvest their earnings back into the business.
Evaluating a Company's Potential for Growth
Assessing a company's potential for growth requires a combination of objective and subjective factors, as well as personal judgment. Growth investors may use certain methods or criteria as a framework for their analysis, considering a company's historical financial performance and its position in the industry.
Growth Investing vs. Value Investing
Growth investing and value investing are often considered opposing approaches. While value investors focus on stocks trading below their intrinsic value, growth investors prioritize a company's future potential and may invest in stocks trading higher than their intrinsic value. Growth investors believe that the intrinsic value will grow and ultimately exceed current valuations.
Notable Growth Investing Figures
Thomas Rowe Price, Jr., known as the father of growth investing, established the T. Rowe Price Growth Stock Fund in 1950. This fund achieved an average annual growth of 15% over 22 years, and T. Rowe Price Group is now one of the largest financial services firms globally.
Philip Fisher, an influential figure in growth investing, outlined his growth investment style in his book "Common Stocks and Uncommon Profits" in 1958. His emphasis on research and networking remains relevant in growth investing today.
Peter Lynch, manager of Fidelity Investments' Magellan Fund, pioneered a hybrid model of growth and value investing known as the "growth at a reasonable price" (GARP) strategy.
Example of a Growth Stock: Amazon Inc. (AMZN)
Amazon is considered a growth stock due to its historical and projected earnings per share growth. Despite its large size, Amazon's earnings per share growth estimates for the next five years remain around 30% per year. Investors are willing to invest in Amazon at a high price-to-earnings ratio because they anticipate future growth and potential capital appreciation.
In conclusion, growth investing is a strategy focused on capital appreciation through investments in companies expected to experience above-average earnings growth. Growth investors consider factors such as historical and future earnings growth, profit margins, return on equity, stock performance, and industry potential when evaluating stocks. Growth investing differs from value investing, and notable figures in growth investing include Thomas Rowe Price, Jr., Philip Fisher, and Peter Lynch.
