Growth stocks: what are they and how do you find them?

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Rebecca Cattlin
By :  ,  Financial Writer

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What are growth stocks?

Growth stocks are listed companies with share prices that are expected to rapidly increase in value. They grow at a faster rate than the average stock in the same industry, and so generate earnings at a higher rate too.

Growth stocks are popular among both short-term traders and longer-term investors. While their general trajectory is up, growth stocks experience more volatility than other companies, which can pique the interest of speculative traders looking to go long and short.

Learn about trading shares with City Index today.

 

Characteristics of growth stocks

Any listed company could be a growth stock, as long as they have the potential for capital appreciation – that could be one of the biggest companies in the world, down to a small cap stock. But most growth stocks share a few characteristics that can help you find them, including:

High P/E ratios

Growth stocks aren’t valued on what the companies earn now; their worth comes from the room they have for capital appreciation. For that reason, they’ll often have a high price-to-earnings ratio.

The share price of a growth stock can be driven up, even if profit remains low, in anticipation of growth.

An example would be Tesla, which has traded at a P/E ratio of 90 – meaning its shares are worth 90 times earnings – as investors focus on the EV market’s growth potential over current sales.

But it’s important to remember that the value in a growth stock is in its potential for capital appreciation, you’re looking for a company that still has room to move higher. So, if a business is already overvalued, then it probably won’t grow further in the future.

Learn about other financial ratios.

Unique product offerings

The best growth stocks have – or are about to launch – a product or service that no other company currently offers. If they can ensure that their product takes off before another business catches up, the potential for a long bull run is high.

 

High sales growth figures

Sales history can highlight whether a company is seeing accelerating earnings. To identify increasing sales, you’ll be looking at the revenue and earnings a company brings in over a few consecutive quarters or even years.

The faster the growth rate, the more likely the company is to attract investment. A lot of the most popular growth stocks have double-digit or even triple-digit growth rates.

What you want to avoid are companies that have erratic or slowing growth over a certain time period.

Learn how to read an earnings report.

Being a part of growth industries

Growth stocks can come from any industry, but you’re much more likely to find one in fast-growing industries such as biotech or big data, as these sectors have a high potential for expansion.

Growth sectors may be set to benefit from upcoming legislation or regulation. For example, eco-friendly tech companies are likely to get more attention as governments look for green alternatives to existing fossil fuels.

A focus on spending

Growth stocks don’t often pay dividends because they reinvest all their revenue back into growing the business as quickly as possible.

A large, established company may not expect its share price to rise too quickly. So, they’ll try to attract investors with strong profits and regular dividends. Growth stocks are the opposite. As these companies are generally (but not always) small, they focus on growing revenue with high R&D budgets, marketing spend and wage growth.  

 

A loyal customer base

Evaluating a growth stock using traditional fundamentals can be tricky, so it’s also worth looking at alternative metrics.

Examining the customer base can be one useful avenue. With unique products and a strong focus on developing their output, good growth stocks tend to attract loyal customers – and are bringing more customers in all the time.

To be successful, companies need to have high quality, in-demand products that they’re selling to a large pool of customers. The bigger the target market, the more opportunity for sales.

 

Trading growth stocks with City Index

If you’re ready to start hunting growth stocks, get started with City Index in a few quick steps.

  1. Open an account, or log in if you’re already a customer
  2. Search for the company you want to trade in our award-winning platform
  3. Choose your position and size, and your stop and limit levels
  4. Place the trade

Alternatively, you can practise trading growth stocks first in a risk-free environment with a demo account.

 

Growth stocks vs value stocks

Growth stocks and value stocks are both highly sought after, and they share some similarities. But they aren’t the same. A growth stock is any share that is likely to display fast long-term price growth, while a value stock is a share that is currently underpriced by the market.

They suit different strategies, too. Hunting for growth stocks means finding companies with the specific characteristics that may soon lead to a huge rally. To find value stocks, meanwhile, you assess a company’s fundamentals to decide how much you think it’s worth. If you believe that it’s trading below its value, you buy it.

 

Examples of growth stocks

To really understand how growth stocks work, let’s look at two of the most-talked-about growth stocks from recent years: Amazon and Tesla.

 

Amazon

  • No dividend, despite strong financials
  • High P/E
  • Growth sector: tech

Between January 2015 and January 2021, Amazon’s share price increased by over 974%. In 2021 it reported net income of $33.36 billion, up from $21.3 billion in 2020.

Despite this growth, Amazon is yet to pay a dividend – it attracts investors by delivering high share price growth. And with a P/E ratio regularly in excess of 40, shareholders clearly expect its stock to continue on this trajectory.

Learn about Amazon’s upcoming stock split.

 

 

Tesla

  • Product benefits from regulation
  • High P/E
  • Growth sector: electric vehicles

In many ways, Tesla might be the epitome of a growth stock. It’s been a stock market darling for a while, with valuations far higher than earnings. But its share price has exploded over the last few years – between January 2015 and January 2022, shares of TSLA had risen by over 2275%.

Environmental regulation had a large part to play in Tesla’s growth, as emission credit sales helped increase revenue.

However, Tesla’s share price growth isn’t stable. Its share price is known for its volatility thanks to the efforts of CEO Elon Musk – who has successfully wiped billions off the company’s valuation with a tweet on multiple occasions. In May 2022 alone, Tesla shares have fallen by more than 35%.

Tesla is also frequently on the list of most shorted stocks, thanks to this volatility.

 

Are growth stocks risky?

Growth stocks can be a risky strategy, as like any trade that comes with a higher potential return, they tend to offer a higher degree of risk at the outset.

The main risk is that the company never fulfils its potential to deliver capital returns. This can happen for numerous reasons, such as another business swooping in to take its advantage, or its product becoming irrelevant before it generates revenue.

Related tags: Stocks Equities Insights

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