How to Invest in Growth Stocks?

The stock market gives you ample options for generating returns, irrespective of your investment horizon. Whether you are an investor looking for quick growth or one who prefers less-risky options, the stock market has something for every investor.

If you belong to the first category and looking to grow your investment faster then you may consider investing in “Growth Stocks”.

Wondering what are growth stocks? Read on to find out what they are and how to invest in growth stocks.

What Are Growth Stocks?

Growth stocks are stocks whose growth rate is expected to be significantly faster than the rest of the stocks in the market.

Growth stocks represent equity in companies that tend to be growing their share prices, profits, revenue or cash flow at a considerably faster rate than the market at large. These companies are expected to outperform their peers in earnings and stock performance.

Growth stocks often represent relatively young, smaller companies, or industry disruptors. 

If you are wondering why should you invest in growth stocks, the answer is simple - to earn profits from the rapid price appreciation.

While investment in these stocks is known to offer capital appreciations and great returns, they seldom pay a dividend. Growth companies typically reinvest their earnings to rapidly expand and grow. But that doesn’t discourage investors from investing in growth stocks as investors who buy growth stocks are not looking for dividends, they are looking for the exponential growth of their investment.

One important thing to note here is, good returns don’t come without commensurate risks. There are chances that you could lose value in your investment if the company runs into trouble or the overall market environment is unfavourable.

Now that you understand the meaning of growth stocks, let us tell you how to find growth stocks.

How to Find Growth Stocks?

Although there is no specific formula to find growth stocks, there are certain broad indicators that you may use to spot the growth companies for investment. Consider the following factors:

· Company’s Strength

One of the primary factors to consider while finding growth stocks is to look at the strength of the business. Companies that have a powerful business model, strong foundation, solid business development plan and competent management have massive potential for growth and expansion in the future.

This can be assessed with the help of Return on Equity (ROE) value that is published annually. Companies representing growth stocks typically have 15% or higher annual ROE.

· Price to Earnings Ratio (PE Ratio)

Companies that are earning profits tend to be less risky as compared to companies that have not made money yet. Investors assess the current earnings of the company by looking at the PE ratio that compares current stock price to company earnings.

Companies having growth potential have a high bid value in the stock market. They have a high PE ratio that indicates high returns on investment. A PE ratio of 1 or higher indicates the stock is fairly valued.

A company having a higher PE ratio indicates that its stock’s market value is higher in comparison with its earnings.

PE ratio can be calculated as:

PE Ratio = Market Value Per Share / Earnings Per Share

Let us take an example to understand this better.

Let us say, the market value of XYZ stock is Rs. 100 and the earnings per share is Rs. 75.

Now to identify if this is a growth stock or not, let us calculate the PE ratio.

PE Ratio = 100 / 75 = 1.3.

Since a PE ratio of 1 or higher indicates higher growth potential of a company, XYZ stock can be considered as a growth stock.

Thus, PE ratio can be used as a factor to identify whether a stock can be considered a growth stock.

· Price to Earnings Growth Ratio (PEG Ratio)

There is a limitation of the PE ratio – it only takes into account the current earnings of the company. It does not take into account the rate at which the company grows.

This is where the PEG ratio is useful. It gives you a much clearer picture of the growth potential of the company, especially when the PE ratio is irrationally high.

PEG ratio takes into account the yearly rise in the total earnings per share of a company. It considers the company’s PE ratio as well as its expected earnings growth over a specific period of time.

A company having a PEG ratio of below 1, indicates a stock is undervalued and is a potential buy. If the PEG ratio is 1, it means the stock is fairly valued and if it is above 1, it means the stock is overvalued.

PEG ratio can be calculated as:

PEG Ratio = PE Ratio / Earnings Per Share Growth Rate

Let us take an example to understand this better.

Let us say, the market value of XYZ stock is Rs. 460, earnings per share this year is Rs. 20.9 and earnings per share last year is Rs. 17.4.

Now to identify if this is a growth stock or not, let us calculate the PEG ratio.

Therefore, PE Ratio = 460 / 20.9 = 22

Earnings Per Share Growth Rate = (20.9 / 17.4) – 1 = 20%

PEG Ratio = 22 / 20 = 1.1

Since a PEG ratio of higher than 1 means the stock is overvalued, it may not be considered as a growth stock.

The above-mentioned are the three important parameters to consider while investing in growth stocks.

Open a demat account with Indira Securities to start investing in growth stocks. When investing, you may want to consider your goals and risk tolerance.