Growth Investing: Overview
Growth investing is an investment style and approach that is focused on expanding an investor's money. Growth investors often invest in growth stocks—that is, new or tiny firms whose profits are predicted to expand at an above-average pace compared to their industrial sector or the broader market.
Growth investment is particularly enticing to many investors since buying shares in rising firms may yield spectacular returns (as long as the companies are successful). However, such enterprises are untried, and hence generally offer a rather large risk.
Growth investing may be compared with value investing. worth investing is an investment technique that includes choosing stocks that appear to be trading for less than their intrinsic or book worth.
Understanding Growth Investing
Growth investors often search for investments in fast developing industries (or perhaps whole markets) where new technology and services are being produced. Growth investors strive for profits through capital appreciation—that is, the gains they'll get when they sell their stock (as opposed to dividends they receive while they possess it). In reality, most growth-stock businesses reinvest their earnings back into the business rather than issuing a dividend to their shareholders.
These firms tend to be tiny, fledgling enterprises with high promise. They may also be corporations that have recently started trading publicly. The notion is that the firm will succeed and develop, and this rise in earnings or revenues would eventually convert into greater stock prices in the future. Growth stocks may consequently trade at a high price/earnings (P/E) ratio. They may not have earnings at the present moment but are projected to in the future. This is because they may have patents or have access to technology that put them ahead of others in their business. In order to keep ahead of competition, companies spend money to create even better technology, and they aim to gain patents as a strategy to assure longer-term prosperity.
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 method for determining this potential; it involves a degree of human interpretation, based on empirical and subjective elements, plus personal opinion. Growth investors may use specific approaches or criteria as a foundation for their study, but these methods must be implemented with a company's particular condition in mind: Specifically, its current position vis-a-vis its prior industry performance and historical financial performance.
In general, though, growth investors look at five essential aspects when picking firms that may deliver capital appreciation. These include:
Strong Historical Earnings Growth
Companies should exhibit a track record of substantial profits growth over the last five to 10 years. The minimum earnings per share (EPS) growth depends on the size of the company: for example, you would aim for growth of at least 5% for firms that are bigger than $4 billion, 7% for companies in the $400 million to $4 billion range, and 12% for smaller companies under $400 million. The main premise is that if the firm has exhibited strong growth in the recent past, it’s likely to continue doing so moving forward.
Strong Forward Earnings Growth
An earnings release is an official public disclosure of a company’s profitability for a specified period—typically a quarter or a year. These announcements are made on certain days throughout earnings season and are preceded by earnings forecasts released by equity analysts. It’s these estimations that growth investors pay special attention to as they try to predict which firms are likely to expand at above-average rates relative to the industry.
Strong Profit Margins
A company’s pretax profit margin is computed by subtracting all expenditures from sales (excluding taxes) and dividing by sales. It’s a crucial measure to evaluate since a firm might have amazing growth in sales with low improvements in earnings—which could signal management is not controlling expenses and revenues. In general, if a firm outperforms its prior five-year average of pretax profit margins—as well as those of its industry—the company may be a potential growth possibility.
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Strong Return on Equity (ROE)
A corporation’s return on equity (ROE) assesses its profitability by demonstrating how much profit a company earns with the money shareholders have contributed. It’s determined by dividing net income by shareholder equity. A decent rule of thumb is to compare a firm’s present ROE to the five-year average ROE of the company and the industry. Stable or growing ROE implies that management is doing a good job earning returns from shareholders’ capital and managing the firm effectively.
Strong Stock Performance
In general, if a stock cannot reasonably double in five years, it’s generally not a growth stock. Keep in mind, a stock’s price would quadruple in seven years with a growth rate of only 10%. To double in five years, the growth rate must be 15%—something that’s clearly doable for fledgling enterprises in fast developing industries.
Growth Investing vs. Value Investing
Some regard growth investment and value investing to be diametrically opposing methods. Value investors seek "value stocks" that trade below their intrinsic value or book value, whereas growth investors—while they do examine a company's underlying worth—tend to overlook typical signs that would suggest the stock to be overvalued.
While value investors seek for stocks that are trading for less than their inherent worth today—bargain-hunting so to speak—growth investors focus on the future potential of a firm, with far less attention on the present stock price. Unlike value investors, growth investors may acquire shares in firms that are selling higher than their intrinsic value with the idea that the intrinsic value will rise and ultimately exceed present prices.