What Is a Growth Stock?

Growth stocks represent companies that increase sales and earnings faster than the market. The strong business performance inflates the stock price, creating big capital gains for shareholders.

If beating the market is among your investing goals, growth stocks are on your radar. Read on for a look at growth stocks, how to evaluate them, and how to know whether growth stock investing is right for you.

Understanding growth stocks

Growth stocks pursue aggressive expansion of their sales and earnings. They can do this by creating new markets, launching new products, growing market share, expanding into new territories, and acquiring complementary businesses.

These initiatives require funding, which can come from ongoing operations, equity financing, or debt financing. Profitable growth companies typically tap their excess cash flow first, which explains why most growth stocks don't pay dividends. Companies with a pipeline of compelling initiatives can often generate better shareholder returns by investing in expansion versus paying dividends.

Growth investors accept this strategy on the assumption they'll be rewarded later with outsize capital gains. If the expected growth doesn't materialize, investors will lose confidence, and the stock price will fall.

Growth stocks are often contrasted with value stocks, which usually pay dividends and exhibit slow and steady growth over time.

Characteristics of growth stocks

Growth stocks can be big or small companies. They can operate in any industry, although many are involved in some form of technology. The characteristics these stocks share are more nuanced than size, age, or market segment. They include competitive advantages, an innovation focus, experienced leaders, and a large addressable market.

Competitive advantage

Growth companies can move quickly and efficiently to outperform the competition. Often, that means they're benefitting from one or more advantages they hold over their peers. Those advantages can involve intellectual property, size and scale, or loyal customers.

Note that customer loyalty can arise in different ways. It can come from an attachment to the brand, from costs associated with switching to a competing product, or from what's called the network effect.

The network effect is the increase in the value of a product or service that happens as more people use it. This is easiest to understand in reference to social media platforms, which become more interesting as users invite their friends and add content.

Innovation focus

Growth companies often use innovation to create new solutions that align with longer-term trends. Tesla (TSLA -0.84%), for example, capitalized on rising demand for electric cars by building models that were faster and more fun to drive than existing options.

Experienced leaders

Evaluating, selecting, and implementing business growth plans is not the stuff of college assignments. Successful growth companies need experienced and disciplined leaders to turn ideas into bottom-line results.

Large addressable market

Growth companies tackle big, global opportunities. Tesla sells cars around the world. Apple (AAPL -1.66%) does the same with smartphones, laptops, and tablets. Amazon (AMZN -1.85%) retails and wholesales hundreds of millions of products across a portfolio of country-based marketplaces.

Note that growth stocks can look overvalued based on price-to-earnings (P/E) ratios and other valuation metrics. This is because investors assume growth stocks will deliver higher earnings in the future. As a result, they're willing to pay more relative to current earnings.

Even so, you can pay too much for a growth stock. Your risk tolerance and timeline can guide you here. If you can handle risk and have a long investment timeline, you may be more accepting of aggressive valuations.

Qualities of growth stock investors

Growth stocks are wealth generators, but they're also expensive and volatile. That type of investment demands a methodical, rational, risk-tolerant, and patient investing approach.

Methodical

It's crucial to have a process for evaluating growth stocks and making trade decisions. Our guide to value investing and our guide to growth investing are great places to begin.