Growth investing is a stock-buying strategy that focuses on stocks that show great potential for growth at a pace that’s faster than their industry sector or the overall market. Growth investors typically look for small or up-and-coming companies whose earnings are expected to grow faster than the industry to add to their portfolios.
While every person’s investments should align with their personal financial goals, there are certain rules and strategies that benefit practically any individual growth investing plan. In this guide, we’ll explain growth investing strategies in more detail, and exactly what those rules and strategies are.
Growth Investing, The Basics
Growth investing is investing in small or young but potentially high-earning businesses or entire industries that grow at an above-average rate compared to the market. These are typically startups in rapidly growing sectors whose stocks have good future potential.
While growth stocks of such small companies may not have high earnings at present, growth investors expect that the companies will grow and expand in the future, which will result in higher stock prices.
A Company’s Potential for Growth
So what are the companies that growth investors like to invest in? Typically, these are startups in hot sectors like artificial intelligence, robotics, biotechnology, financial technology, etc. In other words, the businesses that deal with emerging technologies and healthcare that constantly develop innovative hardware and software related to those sectors or niches.
If a proper, thorough analysis is done, the future returns in such companies can be incredibly high. But precisely because of this, the risks can be high, too. And evaluating a company’s potential for growth is no easy task; if it were, everyone would be doing it.
This said, there are certain rules that all growth investors can follow when doing company analysis and evaluating its growth potential.
Here are five of them.
1. Historical Growth
While the businesses that growth investors choose are typically small and young, historical growth is still one of the most important factors to consider in company analysis. Startups worth investing in show a track record of increasing earnings over the past several years.
It’s important to note here that earnings are what is left over after deducting operating, labor, marketing, and tax costs from a business’s gross revenue. Bear in mind that many of these companies are small, so it’s not uncommon for them to invest more capital in growing their business, which may negatively impact their earnings in the short-term.
So when looking at historical growth, make sure you consider other factors, too, if the company shows potential otherwise.
2. Profit Margins
While a company may have great sales, its earnings may not be great at all. This is why a company’s pretext profit margin – or its operating efficiency before deducting taxes – is critical to consider.
If the startup has a great number of sales but negative earnings, it’s more than likely they have a problem with controlling costs. The best-case scenario is a company that exceeds the five-year average pretax profit margin.
3. Return on Equity
A company’s return on equity (ROE) is a profitability metric that shows the relationship between its profit and the shareholder’s return. It’s calculated by dividing the company’s net income by its average shareholder equity. If the ROE is good, this tells you the business is smart with its money and operates efficiently.
When looking at a company for growth investing, compare its present ROE to the five-year average ROE of the company and the industry. A company with great potential for growth investment will have a high return on invested capital.
4. Price-to-Earnings Ratio
The Price-to-earnings ratio (P/E) is one of the best ways to learn whether a startup is overvalued or undervalued. It shows a company’s share or stock price ratio to its earnings per share, and is calculated by dividing the stock’s current price by its latest earnings per share.
Generally speaking, a high P/E suggests that a company has a high level of earnings growth and is a great candidate for growth investing. After investing in a stock, using stock management software to track growth and progression is always a good idea as well.
5. Stock Performance
Stock performance is measured by its fluctuation in price. When looking for growth companies, look for businesses with strong stock performance or those with increasing stock prices.
Growth investors should look for bargain stocks for long-term growth, whose prices can double in five to seven years. In other words, investors should look for undervalued stocks – those that have market prices that are less than their intrinsic value – that they can sell when they rise.
Conclusion
Growth investing is a strategy that focuses on increasing the investor’s capital by investing in growth stocks or startups with high growth potential.
Growth investors can use several different methods or criteria to spot growth stocks and grab them at lower prices while minimizing risk and maximizing long-term investment. But in the end, since growth stocks are highly risky, it is up to each individual investor to exercise personal judgment and choose the methods that work best for them.
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