What are Growth Stocks and How to Analyze the Best Growth Stocks?
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If you are wondering how to identify and pick the best growth stocks with strong fundamentals…then this article is for you.
In this article you will learn:
- What is growth investing?
- What are growth stocks?
- Characteristics of a growth stock
- What should you look for before investing in growth stocks?
- Why should you invest in growth stocks?
- Alternatives to Investing in growth stocks
So, let’s begin.
What is Growth Investing?
Growth investing focuses on investing in companies which are growing rapidly. Companies from sectors like Bio-technology and IT generally grow faster than other companies. Investing in companies which are growing their sales or profits rapidly is known as growth investing.
What are Growth Stocks?
Growth stocks are stocks that have high growth potential. These stocks are expected to grow faster than the average growth of the market. They can also lead to massive wealth creation over time.
Growth stocks have the potential to earn above average returns because they have these characteristics:
- The stock belongs to a booming industry.
- The stock has a competitive advantage which justifies its potential to grow. This competitive advantage can be a new product, future expansion plans, monopoly, etc.
- The company has come up with an innovative strategy and has made technological advancements.
Characteristics of a Growth Stock
1. Growth stocks are valued at a premium
Growth stocks are valued at a premium because they provide higher returns than their peers. Hence, the stock has a highp rice to earnings (PE) ratio and a high price to book (PB) ratio. Both of these ratios evaluate the valuation of a company’s stock.
A high PE shows that investors are willing to pay a higher price to buy the share because of rapid future growth expectations.
2. Growth stocks rarely pay dividends
Growth companies either pay low to no dividends. It is because these companies have a motive to grow at a fast pace. Hence, they prefer investing their profits back into the business to earn extra profits. As the company starts to grow the investors get returns in form of capital appreciation of share.
For example, the dividend yield of Avenue Supermarts is 0%. It means they prefer to reinvest their earnings back in the business.
3. Growth stocks have a competitive advantage
Growth companies usually have a unique selling proposition (USP) which attracts a large customer base. Apart from this, the company also has a competitive advantage over its peers. Hence, they grow better than others in the same industry.
4. Growth stocks have a high risk and reward ratio
Investments always have some amount of risk and so does growth stocks. As the stock pays low or no dividends…the investor’s only profit is the capital appreciation in the long term. So if the company performs well in the future that’s when the investors will make profits.
Hence, these companies are a bit riskier than stable companies with average growth rate.
5. Growth stocks have a loyal and growing customer base
Since growth companies have a moat of their own, they tend to have a huge and growing customer base.
What should you look for before investing in growth stocks?
1. Rising Revenue and Operating Income Margins
Revenue growth and operating margins are the two most important factors which will help you analyse a company better.
- Revenue is the total income generated by a company.
- Operating income is the company’s gross profit recorded in the income statement.
A company with constantly increasing revenue growth and margin is considered to be an appropriate one to invest.
For example over the last 5 years Bharat Rasayan has seen strong growth in its revenue by 21.9%. Also, the company has been maintaining its operating profit in the range of 18-19%. This shows that the company is not only generating profits but is able to manage its expenses well.
2. The pace of net profits over a long term
Net profit is the total profit of the company after operating costs, taxes, interest and depreciation has been deducted.
Consistent growth in net profit indicates the success of a business.
For example in the last 5 years, Britannia has seen fast growth in its net profits by 20.3%
3. Increasing Return on Equity (ROE) and Return on Capital Employed (ROCE)
- Return on equity (ROE) refers to the profits generated on equity capital.
- Return on capital employed (ROCE) refers to how efficiently a company utilizes the available capital to generate additional profits.
While analysing the best growth stocks you must look for high ROE and ROCE. A company with high ROE and ROCE indicates that it is making good use of all the available resources.
4. Earnings per share (EPS)
EPS is the net income earned for every outstanding share. A high EPS means that the investment is worthwhile.
As the share price rises, the EPS also tends to rise. However, you must check for earnings growth of the past 5 years and check for consistent returns.
If a company is providing consistently good returns, then the stock is worth investing.
5. Look for booming sectors
If you want to invest in growth stocks watch out for sectors which can be future game changers. Investing in stocks from booming sectors can help you create massive wealth overtime.
Check out our video on how you identify the best growth stocks to buy in India
https://youtu.be/nQ9rtG6NhK0
Why Should You Invest in Growth Stocks?
1. High returns
Investing in the best growth stocks can help you earn high returns over time. These companies focus on expanding their business to generate revenue. The investors who invest in these stocks can earn a substantially huge capital gain in the long term.
But high returns come by taking a high risk and growth stocks are one of a kind. These stocks are more sensitive to market volatility in the short term. Hence, it is recommended to invest for the long term.
2. Hedge against inflation
Returns earned by investing in the best growth stocks is comparatively higher than the average returns provided by other stocks. So, it’s safe to hold a few growth stocks in your portfolio. By doing so you will be able to earn good returns in a diversified manner.
Alternatives to Investing in Growth Stocks
Growth Mutual Funds
Growth mutual funds primarily invest in growth stocks with the aim to achieve maximum capital appreciation.
The companies selected in the growth funds are the one which has a proven track record of generating high revenue.
List of Best Growth Mutual Funds
Should you invest in growth stocks?
Growth stocks are suitable for investors who have a long term horizon. You must consider investing in growth stocks if you are an aggressive investor.
However, if you are heading towards retirement then it is recommended not to invest in these stocks as they are highly volatile.
But millennials can invest in growth stocks for massive wealth creation in the long term.
To conclude, a successful growth plan can only be achieved in the long term.
So, start investing in long term growth stocks by opening a Demat account at Samco - India’s best discount broker awarded by CNBC Awaaz.