What Are Growth Stocks?

What are growth stocks? How are they defined, how can you find them, and – most importantly – how can they help you turn a profit?

This article will cover this important subject by explaining what growth stocks are and how they’re calculated, as well as providing examples of growth stocks and how you can take advantage of them for your own gain.

Defining Growth Stocks

There are a million and a half ways to classify stocks in the stock market. Fortunately, you can group them into two general types: growth stocks and value stocks.

Value stocks are stocks that are undervalued or underpriced. In other words, the stock price that you see on the scrolling ticker on the bottom of your screen is lower than it should be, if we go by the company’s worth. We figure out if a company is worth more than its stock price suggests by looking at a combination of technical and fundamental factors.

Most value stocks have low price-to-earnings (P/E) ratios, high dividend yields, low price-to-cash-flow ratios, and stocks with a market value (generally, the stock price) that is lower than the book value (how much the company’s net assets are worth).

The general theory is that by buying undervalued stocks, you can take advantage of discounts or bargains. It’s like buying a foreclosed house for $50,000 that has a market value of $100,000.

Growth stocks, simply put, are what you would call “hot stocks” in that they have higher cash flows and report better earnings than the rest of the market or sector. There are a few terms and metrics you can use to determine what is and isn’t a growth stock, such as:

  • Positive cash flow: These companies bring in more cash than they spend over a period of time
  • Return on equity (ROE): Growth stocks have higher ROE than average. You calculate this by taking the company’s net income and divide by the average common equity, or the average amount of a company’s total assets minus its total liabilities. Growth stocks have a minimum of 15% ROE
  • Earnings per share (EPS): These companies report current earnings per share of 20-25%. You calculate this by dividing total net income (minus preferred dividends) by the number of common shares that are in the market. This is an indicator of how profitable a company is
  • Annual earnings: Growth stocks report higher annual earnings than other stocks. Some analysts point to 25% gains in annual earnings or more for the last three years

In addition to those factors, you have to look at the company itself and what it actually does. A lot of times, a growth stock will represent a company that is innovative, popular, and a leader in its field.

If a company consistently turns out new products, or has consistently-high trading volume, or can deliver things on a routine basis that excite investors and the public alike, it could be a growth stock.

Why Buy Growth Stocks?

The main reason you would buy growth stocks is because you want to invest in a stock that is expected to grow in value and continue growing. You want to increase the value of your stock portfolio, and want to do it consistently.

In plain and simple terms, growth stocks can give you the potential for a bigger gain.

Does this mean that you should only buy growth stocks? There are strategies out there that say you should focus mostly on these picks – most famously the CAN SLIM strategy created by investing guru William O’Neil back in 1953.

But, many analysts think you should use a mixture of growth stocks with value stocks and other types in your portfolio, just to make sure you avoid the excess volatility (how much a stock’s price goes up or down over a period of time) that comes with some growth stocks. On many occasions I don’t agree with the analysts, but on this occasion I do.

The bottom line: If you want to put your money in a company that beats its peers in its sector and the market as a whole by bringing in more money each quarter and grows at a faster rate than all the rest, growth stocks are for you.

Some Common Examples

One of the best places to find growth stocks is to look at the technology sector. The tech sector is full of growth stocks because technology companies like to reinvest in themselves. They take the excess money they generate – called retained earnings – and put it back into the company instead of pay it out to shareholders through dividends.

Apple (AAPL) is a great example. Apple meets or has met virtually every single metric discussed above; it has positive cash flows, higher-than-average ROE and EPS, and annual earnings that just keep going up. Plus, Apple is recognized as an innovator and drives the world crazy whenever it releases a new product. It also likes to save its money or reinvest it into the company, which is why they just recently decided to offer a dividend.

Google (GOOG) is another example. Google released its initial public offering in 2004 for $85 per share; within three years, it hit $700 per share. The company reported massive revenue growth and EPS growth year after year.

You don’t have to be a giant like either of those two to be a growth stock, nor do you have to be a tech company – Exxon Mobil (XOM) is a growth stock. Just follow the guidelines outlined above and you’ll be able to find growth stocks – and the potential for profit – in no time.

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