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Growth, dividend, value… what’s the difference? Many would-be investors find themselves looking at the lists of mutual funds and stocks on their portfolio websites and simply get overwhelmed by the number of options.
There are several things to know about the goal of each type of stock because a company you know and love might not be the best choice for your financial goals.
If you’re buying a stock like Chevron for the goal of growth, you may find that to be difficult.
Let’s go through what a growth stock is and how it compares to the other categories of stocks in the market.
What Are Growth Stocks?
Some companies gain a lot of media attention day after day, quarter after quarter, because their stock price simply seems to never go down.
These companies are typically those that are in the process of growing their value either by offering new services or products, merging with similar companies, or acquiring smaller companies.
However, Lululemon is also a growth stock, as is Etsy.
These companies have found ways to grow their revenues, share prices, cash flow, or a combination of these faster than the rest of the market.
>> Learn More: Read Our Guide on How to Start Investing
Growth Stocks vs. Value Stocks
Value stocks and growth stocks might be considered opposites at times.
Value stocks represent those companies that are undervalued by the market.
Where growth stocks represent companies that rise above the curve, value stocks represent companies that fall below the curve.
It’s important to remember that stocks can change from one category to another depending on how the company’s stock performs related to its total value or “market capitalization.”
To illustrate this point, Apple was considered a value stock at one time. Apple reached a low point in 2016 when its products had reached some stagnation.
There was brief talk that the company would never see its peak again.
However, the most famous value investor in history, Warren Buffett, made it clear that Apple was a value stock when he bought 10 million shares back in 2016.
Ever since 2016, Apple has been a growth stock, smashing records in sales and acquiring strategic companies.
The idea is to find companies with strong potential and good leadership who may just struggle through the doldrums for one reason or another.
Value investors find these companies and buy them to sell once they turn around and start showing growth.
>> More:Growth vs. Value Investing
Dividend Stocks vs. Growth Stocks
The third category in the cycle of a stock’s performance is mostly the company choosing a different direction regarding their stockholders.
Instead of using capital to increase the stock price, some companies made the choice to move toward paying out dividends to their shareholders.
Dividends are cash payments that shareholders earn from the companies they invest in on a set schedule, usually quarterly.
This is in lieu of shareholders increasing their portfolio through stock value increases as one would expect of growth stocks, which do not typically pay dividends to shareholders.
While a company can switch relatively easily between value and growth categories, a company’s decision to become a dividend-paying company is usually an indicator that the company feels strongly that its stock price is right where it should be and does not need to grow.
Once a company begins paying dividends to investors, it is usually a permanent choice.
If a company were to stop paying dividends, it could be a signal that the company’s board is making changes that may or may not benefit investors.
In other words, dividend companies inspire confidence until they no longer pay dividends, or their dividend payouts change drastically from their historic levels.
>> Next Steps: Explore the Best Online Stock Brokers
Are Growth Stocks Risky to Invest in?
That depends heavily on what the market is doing. If you didn’t invest in growth stocks until today, you’ve probably missed out on a great big pile of returns.
2020’s crash notwithstanding, the growth stocks have been vastly outperforming the broader market since 2008.
When the market labels a stock as a growth stock, it’s generally because it has already outperformed the market for a period of time.
That’s not to say it won’t continue that growth, but it can be risky to buy anything when it is already making new-high stock prices regularly.
How to Evaluate Growth Stocks
It would be a stretch to say that this information is easy to find, but those investors eager to find and invest in growth stocks can do so by focusing on these points:
There are three ratios that investors will find benefit in calculating.
You might think it’s difficult, but a few Excel entries might help you keep track of things. The ratios can be found in earnings reports and finance websites.
Calculating gross profit margins, operating profit margins, and net profit margins will allow investors to determine how a company is doing.
Comparing these to other companies in the same sector will help confirm rising profit margins above the average.
Manageable Debt Levels
Contrary to what personal finance gurus will tell you, there is such a thing as good debt. A company that takes out debt that can result in provable increases in market capitalization is a strong bet.
Companies that carry heavy debt loads are not ideal for growth because growth stocks depend on profits to re-invest in the company.
If much of the revenues are paid out to cover debt interest and principal, growth is very difficult.
Strong Earnings Growth
Analysts are generally eager to publish their future earnings projections.
While you can always go back and see the history of earnings growth, it’s important to learn what decisions the company is making and use that to figure out the anticipated growth rate.
Strong Sales Growth
Obviously, growing sales are a good indicator of a growth stock.
If a company has a breakthrough in their market or purchases a company or competitor that does, this will help increase sales.
Good Executive Leadership
This is difficult to learn unless you can actually meet the board of directors.
However, review the bios and quarterly reports relating to each executive to get an idea of their specialty, what they’ve produced for the company, and whether they can keep doing so.
>> Learn More: Find out How to Research Stocks
What Are Some Examples of Growth Stocks?
How to Fit Growth Stocks in Your Portfolio
Investing in growth stocks has more to do with the investor’s risk tolerance and time to retirement.
Growth stocks and growth stock funds carry more risk than other options because the value depends on continuous growth, which is not guaranteed.
If you prefer to manage your investment by yourself, then you can take the time to put together the data you need to evaluate companies based on their earnings reports and allocate money to those stocks.
Use the criteria we mentioned above to develop an objective of a company’s performance, then feel free to invest in what way seems best for your account size.
Alternatively, you can invest in growth stock funds, which are actively managed by investment firms.
You can choose from growth funds with lots of stocks included in the holdings, but the diversification may actually hinder growth.
Growth funds with fewer stocks included may have more expensive management fees attached, but fewer stocks may allow for more increases in value.
Use your best judgment and check the performance history of the fund manager.
Funds with good performance since before 2008 would be best.
Who Should Invest in Growth Stocks?
If you are a younger investor, growth stocks will be a welcome addition to your portfolio. They will expose you to a stronger than normal increase in your portfolio value over time.
Expect drops in value as the years pass because the market will correct and experience turbulence from time to time, but the growth stocks and funds will allow you to jump back into recovery phases much faster.
If you are closer to retirement, it may be riskier for you to invest in growth stocks. Invest carefully if you have a passive approach to your investments.
Bottom Line: What Are Growth Stocks?
Growth stocks are those that represent companies that are outperforming the majority of the market without issuing dividends to their shareholders.
There are always risks to investing in growth stocks, but with enough time, they can provide investors with a greater increase in portfolio value.
Be sure to evaluate the companies for growth potential based on profit margins, debt levels, earnings and sales growth, and strong leadership.
These criteria may not be exclusive, but they will certainly help verify whether a company may continue to provide growth in the future.