Growth stocks are stocks whose growth rate is expected to be considerably faster than the rest of the stocks in the market. Typically, growth stocks belong to companies that are growing and relatively young. Of course, there is no specific formula to spot a growth company or stock, nor are there set answers on how to invest in growth stocks.
However, there are certain broad indicators that an investor may be able to spot with adequate research and agility. Before learning how to invest in growth stocks, it would help to understand what characterizes them. Here are some attributes of growth stocks:
- Because a growth company tends to reinvest its own earnings, it may pay low or zero dividends to its stockholders. Investors are also alright with shelling out more for growth stocks because the returns tend to be high.
- Growth stocks are more reactionary to market volatility so the risks involved in investing are also high. Before you invest, you should assess your risk profile and your goal.
- Still, wondering how to find high-growth stocks? Have you paid attention to their earnings per share (EPS)? The EPS is computed with this formula: net profit or profit post-tax divided by the total number of shares outstanding. With the growth in EPS, the stock price also tends to grow. However, it helps to check the earnings growth over the past five or more years to check for consistency. If a company’s growth has been consistently good, chances are the future is also sound.
- Growth stocks may belong to companies that are typically market leaders. They also belong to companies that broaden their markets and step into new territories, ie, companies that are growing.
- The leadership in growth companies is charismatic and committed. Look for the C-suite that has invested a part of its personal wealth into the company shares — it’s a great way to judge that the confidence levels in the future growth of the company are high.
Pay attention to growth sectors
One more answer on how to invest in growth stocks lies in the sectors they come from, and the competitive edge such companies have over others. Researching sectors that grow in relevance for the times we live in may also help.
For instance, recent times have seen growth stocks emerging from companies that are part of the tech sector, simply because there have been several disruptions in the world of technology. This could be a new product or piece of tech that has turned out to be a game-changer across all industries and is being widely adopted. However, this doesn’t mean the technology is the only sector that throws up growth stocks. A close watch of the upcoming and game-changing sectors could help.
How to find growth stocks with the help of PEG ratio
Although all the above attributes are important, one more answer to the question on how to find high growth stocks lies in the price to earnings growth (PEG) ratio. This ratio is calculated thus: PE ratio/growth rate, where PE stands for price-to-earnings ratio. The growth rate is the estimated future earnings rate.
The PE ratio is used by investors to understand a stock’s market value in comparison with its earnings. It acts as an indicator of a stock’s market valuation apart from the price investors are willing to shell out for the earnings of a company. A high PE ratio may be interpreted as high price of a stock vis-a-vis its earnings. It could mean that a stock is overvalued. On the flip side, a low PE ratio means the price of a stock is low vis-a-vis its earnings. However, stocks that have higher growth trade at larger multiples than stocks with lower future growth, so the PE ratio doesn’t indicate much about future growth prospects.
That’s the limitation of PE ratio: it only takes into account a company’s earnings at this point in time. It doesn’t account for the rate at which the company grows.
This is where PEG ratio comes into the picture. Reputed Wall Street investor and author Peter Lynch popularized the concept of this ratio. So, according to him, the PE ratio of a company that is fairly valued will be equal to the growth rate. This is how investors know that a growth stock has been valued fairly. If the PEG ratio is 1, it means the stock is fairly valued. If it’s below 1, it is undervalued and if it’s over 1, it’s overvalued. This is way forward on the question of how to find high-growth stocks.
The PEG ratio is a useful tool that provides answers to the question of how to find high-growth stocks. But it is not the only tool one should rely on. There could be other factors including the growth company’s business model, its past performance, and its position in the sector it is placed in.
How to invest in growth stocks?
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In conclusion, investing in growth stocks is a high rewards proposition that comes with its own risks. Any stock investments come with a certain amount of risk involved, so it is appropriate that you seek expert advice while also doing your research on the subject.