Glossary · Stocks and markets
Growth stock
A growth stock is a share of a company whose sales and profits are expected to grow much faster than average, usually priced high compared with today’s earnings.
Also called: growth company, growth investing, growth shares
In plain words
A bakery that sells the same number of cakes every year is steady. One that doubles its customers every year, opening shops in new cities, is something else: investors pay up today for the profits they expect tomorrow. Its shares are a growth stock.
Growth companies usually reinvest everything to grow faster, so they pay little or no dividend. Their P/E ratios are high, sometimes 50 or more, or they have no profits yet at all. Many are in technology, but any fast-growing business counts.
The opposite style is value investing: buying companies whose shares look cheap compared with their profits or assets.
Example
Paying today for tomorrow’s profits
- Rocket Co. earns $1 a share and its shares cost $50: a P/E of 50.
- If its profits grow 30% a year, they reach $3.71 a share in five years. At $50, that is a P/E of about 13.5 on those future earnings.
- If growth slows to 10% a year, profits are only $1.61 in five years. Even at a still generous P/E of 25, the price would be about $40: a 20% loss.
A growth stock’s price is a bet on growth that has not happened yet: right, and it can pay handsomely; wrong, and the fall can be steep.
One level deeper
Growth investing looks for companies with big markets, strong products and the ability to reinvest at high returns. The best of them compound for decades: today’s largest companies were once small growth stocks.
Growth stocks are more sensitive to interest rates: most of their value lies in profits far in the future, and higher rates make future dollars worth less today. That is one reason they fell hard in 2022, when rates rose fast.
Over long periods, research by Eugene Fama and Kenneth French found that US value stocks earned more than growth stocks on average, but growth won for most of the 2010s. Which style leads changes from decade to decade.
Why it matters
Growth companies drive innovation and much of the stock market’s long-run gains: a small number of huge winners produced a large share of all the wealth the market created.
Their high valuations make them swing more: they tend to soar in booms and fall hardest when hopes fade.
In recent years, a few fast-growing tech giants have made up a large part of the S&P 500.
A common mistake
Myth: A fast-growing company is always a good investment.
In fact: A great company can be a poor investment if its price already assumes even more growth. After the 2000 peak, many leading tech companies kept growing their sales, yet their shares took a decade or more to recover.
Questions people ask
What is the difference between growth and value stocks?
Growth stocks are priced for fast future growth (high P/E, little or no dividend); value stocks are priced low compared with today’s profits or assets. Many funds and indexes split the market into these two styles.
Do growth stocks pay dividends?
Usually little or nothing: they reinvest their profits to grow faster. Some start paying once their growth slows.
Why do growth stocks fall when interest rates rise?
Their value depends on profits far in the future, and the higher the rate used to discount those profits, the less they are worth today. It is the same seesaw as with long-term bonds.
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About the numbers
- This page explains a term. It is not investment advice.