A growth stock is a stock that investors believe will increase in value because the issuing company is growing its earnings more quickly than its peers.
Companies issue stock to raise capital. They use that money to build plants, hire and otherwise seek to increase earnings. Eventually, however, even the fastest-growing firms slow down.
Once that happens, earnings grow more slowly, too. Companies can reinvent themselves from time to time in response to a changing economy, but a large company typically grows more slowly because it and its competitors have absorbed most of the economic opportunity in the market.
Investors thus have to choose between a company that is early in its growth cycle and one that is more mature. The majority of large-cap firms, known as blue-chip companies, are in this latter group.
The smaller, faster-growing companies are thus considered “growth stocks” because there is a greater likelihood that their earnings will increasing substantially over the coming years.
That earnings growth is attractive to investors but it comes at a price. Growth stocks can be more volatile than the overall stock market. They also are less likely to pay a dividend to shareholders.
Dividend payments are withheld by growth stocks because the managements of these firms believe that they can profitably reinvest that capital back into the business. This saves them from having to issue more stock or borrow to finance additional growth.
For the investor, missing the dividends is not a bad thing. Reinvested capital that grows with the company often results in higher share prices in the future. Only when management fails to see new opportunities for growth does it become more logical to give dividend income to the shareholders instead.
Growth stocks are different from small-cap stocks. While fast-growing, small-cap stocks can be far more volatile than growth stocks. Even large, established companies can be growth stocks, for instance, if they are in a growth industry.
Investors also try to differentiate between growth stocks and value stocks. A stock becomes a value stock when its price falls for no easily discerned reason. It seems to be a bargain relative to the underlying business and thus provides a “value” to the investor who moves quickly.
Usually, the price of a value stock soon returns to a level commensurate with the true value of the business but does not continue higher from there.
Growth stocks require in-depth analysis to properly identify. Nevertheless, many mutual funds work to create collections of growth stocks so that investors can choose to buy them in a diversified manner at a low cost.
Similarly, there are low-cost index fund and exchange-traded fund products that focus on holding only growth stocks.
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