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Growth investing has emerged as a parallel strategy to the legacy approach (value investing) and involves paying a higher price for the company’s present financial situation with the expectation of generating gains as a result of the firm’s future performance. Value investing, on the other hand, focuses on identifying companies with robust past performance and appealing growth prospects in up and coming sectors of the economy.
This strategy is particularly attractive for investors who have a relatively small amount of capital as their primary goal is to build wealth by investing in high-risk/high-reward opportunities.
If this sounds like the kind of approach that you would like to adopt for your portfolio, keep reading. This article explains the basics of growth investing, delving into the metrics that investors should look for when trying to identify high-growth companies and some other important details that you will need to know if you plan to adopt this methodology.
What Is Growth Investing?
Growth investing is a methodology that consists of finding companies whose past performance and prospects are particularly promising. Companies that are classified as “growing” ventures tend to display above-average revenue growth rates, elevated profit margins, and high returns on the capital invested as a result of their innovative and disruptive operations.
In most cases, companies that grow at a faster pace compared to their peers will do so by achieving one of the following goals:
- Disrupting an industry’s practices to steal customers from the competition or attracting a previously unserved segment of the market.
- Developing processes that reduce costs dramatically, which results in higher profit margins.
- Tapping on unserved markets or finding unmet needs among a certain group of consumers.
- Coming up with innovative products and services that can be patented or that are hard to replicate by others, which grants the company pricing power and market dominance.
Even though other characteristics can fuel a company’s growth, these describe the leading causes for which companies display above-average growth rates.
The primary goal of a growth investor is to identify these companies when they are still relatively small so that he or she can profit significantly once they fully develop their potential in the future.
Pro Tip: Growth investing is an investment strategy that focuses on looking for companies that are expected to grow at an above-average rate compared to their industry or the broader market.
How Does Growth Investing Work?
The first step to engaging in growth investing is to locate promising industries within a certain economy or globally based on how different trends are evolving. One example of this is the financial technology segment of the financial industry, which has been growing at a fast pace through the introduction of disruptive practices including online brokerage services, online loans, and virtual points of sale (PoS).
Once a promising industry has been identified, growth investors will usually seek the most promising players that have already demonstrated their ability to profit from this growing trend.
These companies will usually display above-average top and bottom-line growth rates while their market share will either be the highest among their peers or will be progressively growing at a pace that could lead them to become a dominant force in their particular space.
At this point, a thorough analysis of the company’s total addressable market (TAM), proposed solution, and product/service offering will be crucial to determine how likely it will be for the business to continue to amass a higher market share in the future.
Moreover, the firm’s financials also have to be scrutinized to analyze the rate at which sales, profits, and margins have been growing historically alongside the management’s ability to execute projects and deliver on its promises.
Once the best companies within a growing industry are identified, investors will ultimately decide if the current valuation is failing to price in the kind of growth that the business can deliver based on its historical performance and untapped addressable market, at which point a decision to invest in the company could be made.
Growth Investing: Popular Approaches
Growth investing is not a straightforward methodology that only looks for one type of company. Instead, multiple approaches can be adopted when attempting to identify the most promising companies based on their growth potential. The following is a list of some of those approaches.
Small-cap stocks are those that have a market capitalization between $300 million to $2 billion and they are typically considered mid-sized businesses that are moving from the early stages of the business cycle to the accelerated growth stage.
When businesses are in this particular stage of their life cycle, their progressive advance eventually becomes noticeable and that results in higher levels of brand awareness and consumer adoption, which should ultimately lead to higher sales.
Finding small-cap companies when they are still hidden gems that have gone relatively unnoticed by institutional investors could result in significant gains for investors who get in early. Think of Netflix back when its streaming service was not a threat to cable companies.
At some point, the stock was trading below a dollar. If you identified the potential of Netflix to become an industry-disruptive force back then you would probably be sitting on thousands of dollars in gains if you bought 100 shares, for example.
Growth stocks are often associated with technology because of the inherently innovative nature of this particular sector of the economy. The tech industry is constantly innovating to adapt to the ever-growing needs of consumers and this makes the entire sector an appealing one for growth investors.
A growth investor could focus on a segment of the tech space rather than trying to be an expert in all kinds of technologies. Some sectors are more difficult to understand than others due to the overly technical nature of the services and solutions provided. Others are easier to understand as is the case with streaming platforms.
With that in mind, focusing on technology stocks is another way to engage in growth investing as long as the investor understands the business model, product, service, and value proposition of the company that he/she will be investing in.
Similar to tech companies, healthcare businesses are also constantly innovating to produce more effective products and services or come up with treatments for diseases or pathologies that are currently difficult to deal with.
As a result, those who have in-depth knowledge of the medical field may benefit from focusing on finding the best healthcare stocks based on their growth potential as a result of a thorough study of their product pipeline and proposed solutions.
One example of this would be Moderna (NASDAQ: MRNA), the company that recently developed a COVID-19 vaccine and whose value has been propelled to the point of being included in the popular S&P 500 index.
Those who understood the potential of the firm’s mRNA technology before COVID-19 have profited significantly from this latest development. However, even though the pandemic was quite an unexpected event, it is highly likely that, in the future, the firm would have found a way to disrupt the pharmaceutical landscape with its other products.
Another approach to growth investing involves taking “informed gambles” on companies whose potential seems very promising even though they have not yet displayed the traditional characteristics that would make them qualify as a pure-play growth stock.
Some of those companies may be trading for pennies on the dollar, also known as penny stocks, but they could be working on products and services that have significant potential or they could be in sectors that may benefit from upcoming regulatory changes, as is the case with weed stocks nowadays.
Even though there are no assurances that they will live up to what investors expect of them, building a diversified basket of could-be speculative stocks might generate significant rewards for growth investors as one or two 10-baggers — companies that multiply their value by ten times — may offset the losses generated by those that failed to deliver the expected outcome.
Pro Tip: Growth investing involves analyzing key metrics when evaluating stocks; profit margins, return on equity (ROE), revenue growth, past and future earnings growth, price to earnings to growth ratio (PEG) just to name a few.
How to Find Growth Stocks
Finding growth stocks is more art than science since even though there are financial metrics that could help you in identifying some possible candidates you’ll still need to do a fair deal of research to analyze their potential. Here are a few metrics that you could look for when trying to short-list your picks.
Return on Equity (ROE)
The return on equity (ROE) metric calculates how many dollars shareholders are receiving for every dollar invested into the business. High-growth companies tend to display an upward trend in their ROE as the progressive improvement of their profit margins should result in higher bottom-line profitability and ultimately in the amount of money that they can produce for shareholders.
Revenue is the blood that keeps companies growing and thriving. Therefore, growth companies tend to display above-average revenue growth rates whether that is achieved by increasing their participation in the markets they currently serve or by progressively introducing more products or services to tap new markets.
Growth investors commonly compare the company’s growth rates with the average for the industry and two to three standard deviations will probably indicate that the company is onto something good.
Historical Earnings Growth
Earnings growth is a straightforward percentage that results from comparing a firm’s earnings for year X with that of the preceding year. It can also be done on a quarterly basis.
Measuring the percentage of annual or quarterly earnings growth of a business is another way to identify a growth company and, similar to revenue growth, the rate at which these results are advancing should be compared with the rates seen by its peers to determine if the firm is growing at a rate that exceeds the average.
Projected Earnings Growth
Analyzing a firm’s historical earnings growth is a good start when trying to identify a growth candidate but past performance does not guarantee future results. Therefore, investors should use financial modeling tools and industry reports to possibly forecast the direction that the business could be taking in the following years as a way to determine if growth is nearing a peak or if the company is just scratching the surface when it comes to its potential.
Reports from analysts from reputed financial services firms like Goldman Sachs, Morgan Stanley, Jefferies, and CFRA may offer the kind of insightful information that investors might find useful to determine the direction that the business could be taking moving forward.
In most cases, it is more rewarding to read industry reports rather than stock reports because sell-side reports on individual stocks might be biased as the companies that issue them profit from the sale of equity and debt instruments from the businesses they analyze.
If earnings are expected to grow faster than the industry’s average in the future, chances are that the stock will continue to deliver further gains as well.
Analyzing how profit margins have evolved will allow a growth investor to identify a company’s ability to improve its earnings-generation capacity by trimming its operating expenses, taking advantage of economies of scale, or negotiating better deals with its key suppliers.
In most cases, consistently higher gross, EBITDA, and net margins are desirable. That said, stalled gross profit margins but consistently higher EBITDA margins would also indicate increased efficiency.
Finally, the positive evolution of net margins should ultimately take place once the company starts to reach higher levels of sales.
Price-to-Earnings-to-Growth Ratio (PEG)
The price-to-earnings-to-growth ratio compares the popular price-to-earnings valuation multiple with the company’s historical or forecasted earnings growth rate to possibly determine if a firm is over or undervalued.
This metric was brought up by the legendary fund manager Peter Lynch and it is interpreted as follows:
- PEG equal to or more than 1 but lower than 1.99: The company is considered fairly valued based on its growth.
- PEG lower than one: The company is considered undervalued.
- PEG higher than 2: The company is considered overvalued.
Examples of Growth Stocks
Growth stocks are mostly found in the “hottest” sectors of the market as those are the ones that are often experiencing the highest levels of innovation and disruption. One good example of a growth stock is Netflix (NASDAQ: NFLX), a company that since 2017 has grown its sales from $11.7 billion to $25 billion by the end of 2020 at a compounded annual growth rate of 28.8%.
During this same period, Netflix’s net income has also jumped from $558 million to $2.8 billion while its return on equity has moved from 18% to 29.6%. Notably, the company’s gross, operating, and net margins have also been evolving quite positively and the combination of all of the above-mentioned factors make Netflix the poster child of a growth stock.
At the moment, Netflix is being valued at 60 times its forecasted earnings per share for the next twelve months. Meanwhile, in the next three years, analysts are expecting to see its earnings growing from $6.08 per share to $16.6 per share at a 40% CAGR. This results in a PEG ratio of 1.5 which is fairly attractive for a company that has demonstrated its ability to deliver this kind of growth in the past.
Examples of Growth Funds
These funds focus on finding companies that have a large untapped total addressable market (TAM) and that have also displayed strong revenue and earnings growth rates and consistently higher profit margins.
The top five largest growth ETFs based on their amount of assets under management at the moment are:
- Vanguard Growth ETF (NYSEARCA: VUG) — $82.47 billion.
- iShares Russell 1000 Growth ETF (NYSEARCA: IWF) — $72.16 billion.
- iShares S&P 500 Growth ETF (NYSEARCA: IVW) — $35.73 billion.
- ARK Innovation ETF (NYSEARCA: ARKK) — $22.49 billion.
- Vanguard Small-Cap Growth ETF (NYSEARCA: VBK) — $16 billion.
Pro Tip: An investor’s time horizon and appetite for risk would be two key factors to determine if growth investing is the right strategy for them. For instance, a person approaching retirement may not fit a portfolio allocation that is heavily weighted in growth stocks.
Benefits of Growth Investing (Pros)
- It is a good stratgey for accounts with a small initial balance.
- Growth companies can deliver sizable gains if investors can spot them before most other investors do.
- Two or three great picks will usually be enough to offset the losses caused by the rest of the less successful stocks in a growth portfolio.
- Investors will be exposed to highly attractive sectors that will often experience higher capital influxes compared to less innovative corners of the market. This often helps in keeping valuation multiples at a high level.
Downsides of Growth Investing (Cons)
- Extensive market research and in-depth analysis of the business model and other qualitative factors are commonly required to identify growth stocks before they explode.
- Growth companies don’t usually pay dividends.
- Companies growing at a fast pace commonly need extensive amounts of capital to keep that pace and that could lead to dilution if the management decides to raise capital via common stock offerings.
- Not all “promising” industries end up living up to investors’ expectations — i.e., internet stocks back in the 2000 dot-com bubble.
Who Should Be a Growth Investor?
Growth investing is a methodology that will probably suit investors who have a high tolerance for risk as the price of these stocks could remain fairly volatile until the business reaches a more mature stage.
With that in mind, growth investing is not the right approach for investors seeking to make a quick buck or for people who need a steady stream of income to cover their living expenses.
Moreover, growth investors will usually specialize in a handful of different fields that they know deeply as that would allow them to identify the hidden gems in each of those industries before they become big names.
FAQs About Growth Investing
These are answers to some of the most frequent questions we get on the topic of growth investing.
What Is Dividend Growth Investing?
Dividend growth investing is a form of growth investing that focuses on identifying companies with cash flows and earnings that have been growing at a pace that should allow them to keep increasing their dividend distributions over time.
The best dividend growth stocks are those that have a long track record of dividend increases while their businesses tend to be fairly mature and stable as that increases the odds that the dividend will continue to grow in the future.
How Is Growth Investing Different from Value Investing?
Value investing focuses on identifying companies that are trading below their fair or intrinsic value.
Meanwhile, growth investing focuses on identifying businesses in up-and-coming industries that have already positioned themselves positively by garnering a large market share, tapping a previously unserved market, or innovating/disrupting a certain core process of the industry that allows them to reduce costs, offer more competitive prices, and increase profitability.
Are Growth Stocks Risky?
In general, growth stocks are considered riskier than value stocks due to the significant value that is given to their future growth.
Since there are no guarantees that this kind of growth will be achieved, investors are exposed to the possibility that the company might fail to live up to these optimistic expectations and this could result in sharp corrections in the stock price.
What Is Speculating?
Speculative operations in the stock market are those that do not involve a proper assessment of the business underlying value and growth prospects, which means that they fall outside the premises of the two most prominent approaches adopted by investors — those being value and growth investing.
One example of stock market speculation is technical analysis. This type of analysis looks at the historical price action of a certain instrument and uses complex mathematical indicators to determine if the price of a stock will move up or down in the future.
Since no emphasis is put on whether that price accurately reflects the value of the underlying business or its growth prospects, traders rely on probabilities instead of sound data to assume positions, much like professional gamblers.
What Makes a Good Growth Stock?
The best growth stocks usually display the following characteristics:
- Their products and services are innovative and disrupt the traditional value proposition of their respective markets.
- They have a strong track record of revenue and earnings growth.
- Profit margins have progressively improved as a result of economies of scale.
- They are deploying a lot of resources every year to keep fueling their growth.
- The valuation of the stock, even though stretched, is justified based on the business’ historical and future growth.
Now that you know how growth investing works, do you think this is the right approach for you? Keep in mind that you may need to further study this topic before you fully engage in picking potential growth companies.
Moreover, make sure you invest in businesses you understand as that should facilitate the process of determining which factors have been driving and may continue to drive future growth for the businesses you will be analyzing.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.