What Is a Growth Stock?

By Catherine Brock – Feb 10, 2024 at 9:54AM

Key Points

Growth companies increase their sales and earnings faster than the market.
Growth stocks can be volatile and are prone to overvaluation.
Growth stock investors expect strong capital gains rather than dividends.
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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.

Person points to arrow trending up on bar graph.

Image source: Getty Images.

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

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 -1.11%), 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 -0.35%) does the same with smartphones, laptops, and tablets. Amazon (AMZN 3.43%) 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.

Growth stock investor qualities

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.

Rational

Growth stock investing can fuel emotional decision-making by investors who want to own "the next big thing." Those emotions can encourage buying at the top of a rally or, worse, selling at the bottom of a trough. The best growth stock investors can pause their emotions and make rational decisions, even as circumstances are changing quickly.

Risk-tolerant

Growth stocks can outpace the market. As an example, the S&P 500 Growth Index fell 29% in 2022 and then grew 30% in 2023. By comparison, the standard S&P 500 Index fell 18% in 2022 and grew 26% in 2023. The risk-tolerant investor can take those swings in stride.

Patient

Patience helps growth stock investors wait out the downturns so they can benefit from the next upswing.

A case study

Growth stock case study: Nvidia

Chipmaker Nvidia (NVDA 6.18%) is a proven growth stock. Here's a look at the company in terms of the growth stock characteristics described above.

Competitive advantage. Nvidia has size and reputation on its side, along with a proven system for designing, testing, and iterating its hardware and software products.

Innovation focus. The company has a history of identifying trends early and developing solutions accordingly. The company created the market for 3D graphics in video games in the 1990s. Now, Nvidia holds a dominant position in chips used for artificial intelligence (AI) and related products, which it started working on in the mid-2010s.

Experienced leaders. Nvidia co-founder Jensen Huang has been president and CEO since the beginning. Co-founder Chris Malachowsky is also a member of the executive team.