Growth Investing Strategy - Capital Appreciation At The Cost Of Higher Risks
Growth investing strategy is focused in stocks with a high growth potential, providing investors long term capital appreciation, but at the cost of higher risks.
Growth investing strategy is focused in stocks with a high growth potential. The objective of this strategy is mostly capital appreciation, but at the cost of substantial risks, making it inappropriate for everyone.
The best way to define growth investing is to contrast it to value stock investing strategy. Value investors are focused on stocks that are trading for less than their apparent worth at this moment, while growth investors focus on the future potential of a company, even if the company is currently trading higher than their current intrinsic worth. Growth investing is based on the assumption, that the companies' intrinsic worth will grow and therefore exceed their current valuations.
Growth stocks most often come from young companies and rapidly expanding industries, especially those related to new technology. Investors' expectation for growht stocks is that they will double in five years. Growth investing profits are realized through capital gains and not dividends as nearly all growth companies reinvest their earnings and do not pay a dividend.
Growth Investing Strategy Guides In 5 Easy Steps
There is no absolute formula for evaluating the growth potential of stocks; like with other strategies it requires some individual interpretation and judgment with a company's and industry particular situation in mind. Growth investors use the following typical guidelines for finding possible growth companies:
Step No. 1 Of Growth Investing Strategy - Checking Historical Earnings Growth
Growth investor should first check the rate at which the company revenue and earnings per share (EPS) was growing over the last 5 or even better 10 years. For the company to qualify for growth stock, revenue and EPS minimum growth should be 5% for companies with market capitalization above $ 4 billion, 7% for companies between $ 400 million and $ 4 billion, and 12% for companies with market capitalization below $ 400 million. If a company was showing a good growth over the last years, it is likely to continue doing so in the next years.
Step No. 2 Of Growth Investing Strategy - Estimating Forward Earnings Growth
Forward earnings are definitely more important when building growth investing strategy than past earnings, but there is one big problem with them - they are projections, estimates made by analysts, the company or other sources. Therefore it is necessary for investor to evaluate the credibility of the source and use some common sense while doing that; for example, an established large cap will not be able to grow as quickly as a younger small-cap tech company. Investor should also focus on the industry in which the company operates and get familiar with the prospects and what stage of growth it is at. For the company to qualify for growth stock, projected five-year growth rate should be of at least 10-12%, although 15% or more is ideal.
Step No. 3 Of Growth Investing Strategy - Determining Pre-Tax Profit Margin
High past and estimated forward revenue growth is good, but only until it proportionately results in higher earnings of the company. How well is the management controlling the costs is therefore very important fact, which can be easily determined by calculating the profit margin of the company. If the profit margin is decreasing while the company is growing, it's likely due to a decrease in profit margin and this should be a warning sign for investors. Beside comparing past to current profit margins of the company, it is also necessary for investor to compare profit margins with competitors. For the company to qualify for growth stock, its current profit margin should exceed its previous five-year average of pre-tax profit margins as well as those of its industry.
Step No. 4 Of Growth Investing Strategy - Determining If Management Can Operate The Business Efficiently
Another important factor to consider when building a list of potential growth stocks while implementing growth investing strategy is to check the business efficiency of the company management, which can be easely quantified by using return on equity (ROE). Like with other steps in this guide, your research should be based on relative on not absolute numbers - you should compare current ROE with the five-year average ROE of the company and the industry. For the company to qualify for growth stock, its ROE representing the efficient use of assets, should be stable or increasing.
Step No. 5 Of Growth Investing Strategy - Does A Company Have A Competitive Advantage?
Investors sometimes forget that when they buy shares they are buying a part of a business and in business it is very important for a company to have some kind of competitive advantage (strong brand name, or a dominant distribution network, patented technology, or a certain uniqueness) in its market, which will increase its sales and profitability in the face of competitive pressure. As well as screening the performance statistics of a company, all the great growth investors take an interest in the actual business. It is not recommended to invest in a highly competitive industry with little pricing power of business over its suppliers and customers.
Benefits Of Growth Investing Strategy
Growth stocks grow much faster than other stocks and significantly outperform the market during bull markets. Growth investors know that if they are invested in good growth stocks during rallies their huge gains will more than make up for the losses they experience during bear markets. With good risk management it is possible to sell out the stock near the top of a growth cycle and avoid buying the stock when it's too late to get in. Growth investing is one of the few strategies that actively seek the next powerhouse stock, the one that can grow from a startup to a Blue Chip.
Growth Investing Strategy Risks
Growth investors, especially those investing in very high growth companies, need to be aware of a number of risks, including:
- High growth cannot be sustained indefinitely, and it is difficult to predict when it will slow.
- Fast sales growth may lead to over expansion of sales relative to available resources, which can cause cash flow problems, most often because of a lack of working capital. For example cash inflows from sales come in too late to pay suppliers for the increase in stocks required.
- Management may be unable to cope with the complexities of a larger business.
Written by: Goran Dolenc
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