What it means
A growth stock is defined by expectation rather than by any accounting rule. The market is paying today for earnings it believes will arrive in future years, which is why these shares often look expensive when measured against current profits.
Growth companies typically plough their cash back into the business through new products, new markets, more engineers and more warehouse space. That reinvestment is exactly why dividends are thin, and shareholders accept the trade because they expect a much larger company later.
The usual counterpart is the value stock, a business trading cheaply relative to its assets or its current earnings. Value investors buy a discount on what exists now, while growth investors buy a claim on what might exist in five years.
You can spot growth stocks from a few markers. A high price to earnings ratio, meaning the share price divided by annual earnings per share, a high price to sales ratio and revenue growing at double-digit rates are the usual signs.
The nuance every manager should hold on to is that growth stocks are unusually sensitive to disappointment and to interest rates. Because most of their value sits in profits that are years away, a small change in expectations or in the rate used to discount those future profits moves the share price sharply.
The label is also a matter of degree rather than a fixed category. Whole sectors drift in and out of the description as their prospects change, and the same company can be described as a growth stock by one analyst and an overpriced ordinary business by another on the same day.
In practice
Real-world examples.
Example
A pension fund splits its equity allocation between a growth sleeve holding fast-expanding technology and healthcare companies and a value sleeve holding banks and utilities. The trustees accept that the growth sleeve will swing more violently in both directions.
Example
A founder preparing for an initial public offering is advised to position the company as a growth stock. That means presenting three years of 30% revenue growth and explaining why every dollar of cash is being reinvested rather than paid out.
Example
An operations manager holding shares in a fast-growing retailer is puzzled that the price fell 15% on a day the company reported record profits. Growth had slowed from 28% to 21%, and for a growth stock the direction of the growth rate matters more than the absolute profit.
Think of it
“A growth stock is a company expected to grow much faster than average-priced for that expectation.
Formula
Calculation
There is no formula that defines a growth stock, but the measure most often used to judge whether one is sensibly priced is the price/earnings to growth ratio, usually written as the PEG ratio.
PEG Ratio = Price to Earnings Ratio / Expected Annual Earnings Growth Rate, with the growth rate written as a whole number.
Take a company whose shares trade at $60 and whose earnings per share are $1.50.
Price to earnings ratio = $60 / $1.50 = 40.
Analysts expect earnings to grow 25% a year.
PEG ratio = 40 / 25 = 1.6.
A PEG of 1.0 is often treated as the rough point where the price matches the growth, so 1.6 says investors are paying a premium and the company needs to beat those forecasts to justify the price.Case study
Seen in the real world.
Verdant Labs is a fictional diagnostics company created purely to illustrate this term. In its first four years as a listed business it grew revenue from $30,000,000 to $90,000,000, paid no dividend and traded on a price to earnings ratio of 55, roughly three times the market average. Commentators in the illustration argued endlessly about whether it was expensive.
In year five, growth slowed to 14% because a large hospital group delayed its rollout. The share price fell by more than a third within a month, even though Verdant was more profitable than it had ever been.
Management in this fictional example responded by publishing a clearer three-year plan and starting a modest dividend, and over the following two years the shares were gradually re-rated as a steadier, cheaper business. The illustrative point is that a growth stock's price is built on a forecast, so the forecast changing is the event that matters, not the profit itself.
Watch out
Common mistakes.
- Assuming a growth stock is simply a share that has gone up recently, when the label describes expected future expansion rather than past price movement.
- Judging a growth stock on its dividend yield, a measure that is close to meaningless when the company deliberately pays nothing.
- Reading a high price to earnings ratio as automatic evidence of overvaluation without checking the growth rate that sits behind it.
Questions
People also ask.
Are growth stocks riskier than value stocks?
Generally yes in terms of price swings, because more of their value depends on events that have not happened yet.
Can a company stop being a growth stock?
Yes, and most eventually do; as expansion slows and cash builds up, a company usually starts paying dividends and gets re-rated as a mature or value business.
Do growth stocks ever pay dividends?
Some pay a token amount to widen their investor base, but a large payout usually signals that management has run out of attractive places to reinvest.
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