Stock market is one of the first things that comes to mind when we think about growing our money. From different investing capital to different investing styles, the stock market has a little something for every investor.
There are many different ways in which one can invest in the stock market. One such, widely popular method, and the topic of our discussion today is investing in growth stocks. Unlike value stocks, or value investing, growth stocks heavily rely on expected earnings growth potential, and as such has become a topic of debate among investors.
In this article, we are going to take a closer look at what exactly are growth stocks, their pros and cons, and answer the pressing question – Are growth stocks worth the higher price?
What Is A Growth Stock?
In the stock market, a growth stock refers to the stock of a company that’s expected to grow rapidly. Growth stocks often have a higher price tag attached to them as they are often associated with companies in rapidly growing industries.
They easily attract investor attention owing to their potential of providing substantially higher earnings per share. Growth stocks come with a high price-to-earning ratio (p/e) which makes them expensive. But oftentimes, they can be cheap, if the company continues to see rapid growth and lives up to its full potential.
Another key thing that sets growth stocks apart in the stock market is the fact that they generally do not offer dividends, as the issuing company tries to reinvest the capital thus generated to further fuel their growth or uses it to generate cash flow.
The higher valuations and the fact that growth stocks are higher priced can make even the most seasoned stock trading experts think twice before buying into them. Let’s take a closer look at the pros and cons of investing in higher-priced growth stocks. This will help us better understand what the debate regarding investing in growth stocks is all about.
Pros of Investing in Growth Stocks
Let’s kick this off by taking a look at the positives of growth investing, and the factors that make it so lucrative.
1. Potential for Higher Returns
Growth stocks are issued by companies that are on the rise, these “growth companies” have everything needed to create winning products and generate high profits. They have the potential to provide investors with unparalleled returns.
These stocks are often associated with companies with an upward trajectory, that are constantly working towards reaching higher and higher goals. Investors can hence expect to gain significant returns on their initial investments, as these goals are met.
Growth companies often operate in emerging sectors that are disrupting traditional industries. We need to look no further than Tesla for example. Tesla came in with an innovative technology and disruptive strategy to take over the already saturated automobile industry. The result? They have now become one of the biggest names, not only in the industry but the world.
And their stock price has constantly reflected the same, with an incredible 920% growth in just the last 5 years.
Hence, investors don’t have a problem getting in early, even if it comes at a premium price, because they are paying for what they think the company is potentially going to be worth one day. Their predictions, if proven correct, can lead to substantial capital gains.
2. Earnings Growth
A notable trait of growth stock issuing companies is their ability to invest in themselves. They use the capital generated from issuing the shares to boost their research and development and work towards penetrating newer markets, reaching more customers, and building a robust brand.
For the investors, this translates to a lack of dividends, given the constant cycle of reinvestment. But they do gain profit as these companies have a potential for achieving high earnings per share (EPS). This keeps the investors interested in them and provides them with the opportunity to make an early investment in a future giant.
3. Outperformance Potential
Historically, there haven’t been a lot of other investment options that have outperformed growth stocks. Time and again, they have shown that they can stay ahead of the curve especially since they operate in industries that are still emerging.
As such, the higher price tag that comes with growth stocks isn’t just for the stock but for becoming a part of an expanding industry in its initial stages. This sets the investors up for, on average, higher than market returns.
Cons of Investing in Growth Stocks
As we have seen so far, investing in growth stocks can lead to exponential returns. But before you fill up your entire portfolio with growth stocks, let us also take a look at the risks associated with them.
1. Valuation Risks
As it is with all things the stock market, with great rewards come great risks. This is especially true in the case of growth stocks. The premium asking price for growth stocks is a result of the optimistic growth expectations attached to them.
Sometimes, these expectations can easily lead to the overvaluation of the stocks. This can result in huge losses for the investors in case the stock experiences a price correction.
2. Limited Margins of Safety
The slightest change in the economy or the company can have a huge impact towards the expected price of the stocks. If as an investor you are agreeing to pay a premium for these growth stocks, then you also have to accept the lack of safety they come with.
If the company faces any challenges, internally or externally, that see them missing growth targets, then it can seriously affect the valuation of their stock, which can tank learning to massive losses.
3. Volatility and Price Swings
In the stock market, things can change within minutes. But when it comes to growth stocks, those minutes turn into seconds.
Unlike value stocks, the market sentiments attached to growth stocks can change in seconds. Any bit of negative sentiment, or negative press can cause a massive swing in the share prices.
Keeping up with the short-term fluctuations caused by the growth stocks can thus be a challenge. Investors would need to stay invested for a long term to even out the highs and lows, further limiting their liquid asses.
Conclusion
In conclusion, there’s no doubt that growth stocks can provide investors with the returns they promise and some more. However, just like any other investment instrument, growth stocks too come with their own set of risks.A high price to book a growth stock needs to be coupled with higher risk tolerance if you are looking to grow your money.
