Growth stocks are shares of companies expected to grow faster than the overall market. These companies often reinvest profits to fuel expansion rather than paying dividends. While they can deliver impressive returns, they also carry higher risk. In this guide, we will explain how to identify and invest in growth stocks.
What Are Growth Stocks?
Growth stocks are shares of companies that are expected to grow their revenues and earnings at a rate significantly faster than the market average. These companies typically operate in expanding industries, have innovative products or services, and prioritize reinvesting profits into business expansion over paying dividends.
Key characteristics: Growth stocks typically have above-average revenue growth (15%+ annually), high P/E ratios, low or no dividend payments, and strong competitive advantages in their industries.
Characteristics of Growth Stocks
Growth companies share several common traits:
- High revenue growth: Consistently growing sales at 15% or more annually
- Strong earnings growth: Expanding profits faster than competitors
- High valuation: Premium P/E ratios reflecting future growth expectations
- Reinvestment focus: Profits go back into R&D, expansion, and acquisitions
- Low or no dividends: Cash is used for growth, not shareholder payouts
- Market leadership: Often dominant players in growing industries
Examples of Growth Stock Sectors
Growth stocks are found across many industries, but certain sectors tend to have more growth opportunities:
Common Growth Sectors
- Technology: Cloud computing, software, semiconductors, AI
- Healthcare: Biotech, medical devices, telehealth
- E-commerce: Online retail, digital payments
- Renewable energy: Solar, wind, electric vehicles
- Fintech: Digital banking, payment processing
How to Identify Growth Stocks
When screening for growth stocks, look for these metrics:
1. Revenue Growth Rate
Look for companies growing revenue at 15% or more annually. Consistent growth over multiple years is more reliable than a single strong year.
2. Earnings Per Share (EPS) Growth
Strong EPS growth indicates the company can convert revenue growth into profit growth. Look for 20%+ annual EPS growth.
3. Return on Equity (ROE)
High ROE (above 15%) suggests the company effectively uses shareholder capital to generate profits.
4. Total Addressable Market (TAM)
Growth companies need large markets to grow into. Evaluate whether the industry has room for significant expansion.
Valuing Growth Stocks
Traditional valuation metrics often make growth stocks look expensive. Use these growth-specific approaches:
- PEG ratio: P/E ratio divided by earnings growth rate. A PEG below 1 suggests the stock may be undervalued relative to growth
- Price to Sales (P/S): Useful for companies not yet profitable
- Forward P/E: Uses projected earnings for a more accurate picture
- Discounted Cash Flow (DCF): Projects future cash flows and discounts to present value
PEG Ratio Example
- Stock A: P/E of 40, earnings growing 40% = PEG of 1.0
- Stock B: P/E of 20, earnings growing 10% = PEG of 2.0
Despite the higher P/E, Stock A may be the better value relative to its growth rate.
Risks of Growth Investing
Growth stocks come with significant risks:
- High volatility: Growth stocks can swing 30-50% in market corrections
- Valuation risk: High expectations mean any disappointment causes sharp declines
- No dividend cushion: Unlike dividend stocks, there is no income during downturns
- Competition: High-growth industries attract fierce competition
- Interest rate sensitivity: Rising rates hurt growth stock valuations more than value stocks
Growth vs Value Investing
Understanding the difference helps you build a balanced portfolio:
- Growth stocks: Higher risk, higher potential return, focus on future earnings
- Value stocks: Lower risk, steady returns, focus on current undervaluation
- Growth tends to outperform in bull markets; value often does better in bear markets
- Many successful investors blend both approaches
Strategies for Growth Investing
Consider these approaches when investing in growth stocks:
- Long-term focus: Growth investing works best with a 5+ year horizon
- Dollar cost averaging: Regular investments reduce timing risk
- Diversification: Spread investments across different growth sectors
- Position sizing: Limit individual positions to manage single-stock risk
- Stay patient: Avoid selling during temporary setbacks if the thesis remains intact
Track Your Growth Portfolio
Pro Trader Dashboard helps you monitor your growth stock investments, track performance against benchmarks, and analyze your portfolio allocation.
Summary
Growth stocks offer the potential for significant capital appreciation but come with higher volatility and risk. Success in growth investing requires identifying companies with sustainable competitive advantages, understanding appropriate valuation methods, and maintaining a long-term perspective. By combining growth stocks with more stable investments, you can build a portfolio positioned for both growth and stability.
Want to learn more? Check out our guides on value stocks and dividend vs growth stocks.