What is Growth Investing & How Does it Work? - No BS Investing
Posted 224 views May 20, 2022, 10:00 - Elisabeth in Investing

What is Growth Investing & How Does it Work?

Think you’ve found the next Google, Facebook, or Amazon?

Growth investing is all about finding and investing in the stocks of these companies! You typically find these companies by looking at their revenue growth rates. They are also often tech companies. Examples of growth companies are Palantir, CrowdStrike, and Shopify.

Below is exactly what growth investing is and how you can get started. 

Key Takeaways:

  • Growth investing is a high-risk, high-reward long-term investing strategy.
  • Value investing is about finding companies that are priced BELOW what they are intrinsically worth. 
  • Growth investing is about finding companies that are priced ABOVE what they are worth right now. 
  • Growth companies have a high price-to-book (P/B) ratio. 
  • Volatility is part of investing in growth stocks. The trick is to invest for the long-term. 

Growth investing is a high-risk, high-reward long-term strategy.

“Growth and value investing are joined at the hip.” – Warren Buffett

Growth investing is a long-term investing strategy where you buy growth stocks from companies with aggressive growth. These stocks are expected to outperform the market. Growth investing is high-risk, but also often profitable. 

Growth investing doesn’t involve investing in companies like utilities. These companies might be stable and pay potential dividends, but they aren’t expected to grow like crazy. 

Emerging industries such as technology companies (e.g., information technology and blockchain technologies) have high-growth potential. They typically don’t pay dividends and are the perfect companies for growth investing. 

IS GROWTH INVESTING THE SAME AS VALUE INVESTING?

Value investing is similar, but not the same thing. 

Value investing is about finding companies that are priced BELOW what they are intrinsically worth. Growth investing is about finding companies that are priced ABOVE what they are worth right now. 

For example, if a company makes $100,000,000/yr, but the market is valuing the company at $90,000,000, then the intrinsic value is worth more than what the market is pricing it at. This is a value investment.

Value investing is based on two principles:

  • Find high quality companies
  • Buy them at bargain prices

You then sell these investments when their stock price matches the company’s actual value. This process can take years, but you earn dividends in the meantime. 

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With growth investing, the stock’s value is higher than the company’s value. Why? Because growth companies gain a lot of attention in the market even though they might not have strong earnings growth yet. Maybe they have a competitive advantage over similar companies. Or maybe they have a loyal customer base. Their future potential is already factored into their initial offering price (IPO). 

The overvaluation of these growth stocks makes them risky. You think they are going to grow, but they might not. They might never live up to expectations and you could potentially lose a lot of money (hint: never invest more than you can afford to lose). 

Still, when you buy a growth stock, you’re not just buying a part of the company. You are confident enough to invest in their future growth. It could take years for these companies to mature, but if they do continue their growth, you could earn fantastic returns. 

As an example, consider Apple. In December 1980, Apple premiered on the stock market at $22 per share. It was a young profitable company, but overvalued. Apple also went through ups and downs over the years which means you would have lost money as a short-term investor. 

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However, according to CashNetUSA, a $1,000 investment in Apple in December 1980 would be worth $651,000 today. Similarly, Amazon went public in 1997. If you had invested $1,000 on Amazon then, you would have $1.43 million today. 

Again, growth investing takes time to see returns, but can be profitable. Growth stocks slightly outperform value stocks when the economy is doing well. Eventually, you expect to sell growth stocks at a higher price than what you bought. 

Growth companies have a high price-to-book (P/B) ratio. 

“The intelligent investor gets interested in big growth stocks not when they are at their most popular but when something goes wrong.” – Benjamin Graham

Price-to-book ratio is the ratio of the market value of a company’s shares (share price) over its book value of equity. Growth investors look for a high price-to-book (P/B) ratio because it shows that their shares are being overvalued compared to their actual worth.

Here’s an example: as of May 2, 2022, Shopify had a price-to-book value of 4.956. This means that the company is trading at almost five times its book value. If a stock’s price-to-book ratio is greater than one, the stock price appears to be trading at a higher price than what the company is worth. 

Take the following steps to calculate price-to-book ratio value for a company:

  • Step 1: Find the market price per share (this number is listed beside any stock’s ticker symbol). 
  • Step 2: Find the book value per share (asset minus liabilities divided by outstanding shares).
  • Step 3: Divide the market price per share by the book value per share. 

Say that you’re thinking about investing in a technology company called XYZ Company. Here’s what you know about the company: 

  • Share price: $20
  • Total assets: $2 billion
  • Total liabilities: $1 billion
  • Outstanding shares: 50 million

Since we already have the share price, let’s get the book value. Subtract the company’s liabilities ($1 billion) from the company’s assets ($2 billion). The book value is $1 billion. Now divide this number by the 50 million outstanding shares. The book value per share is then $20. Divide the share price of $20 by the book value per share of $20. The price-to-book multiple is 1. Also, check if the ratio is higher compared to industry peers and the overall market.  

This number doesn’t have to be calculated manually. You can also find the P/B ratio by using a site like YCharts.

Note: Value investors want a lower price-to-book ratio because this could indicate that the stock is actually undervalued. 

Volatility is part of investing in growth stocks.

“You can’t go to sleep holding cyclical stocks for a decade and expect to be richly rewarded. The rich rewards are in growth stocks and special situations.” – Peter Lynch

Growth stocks can take years to mature. In the meantime, they can experience high stock prices or plummeting prices (aka volatility). You must be comfortable with volatility and not panic every time your company does poorly. 

Take Facebook, for example. Facebook typically performs well as a company and the stock price reflects this. But in recent years, Facebook received backlash because of issues like data privacy. Stock prices dropped. However, the negative news eventually died down, and Facebook is still experiencing an increasing growth rate. 

The trick is to ride out the downturns of your growth stocks. Strong companies should balance out over time. You then sell when the growth stock prices are higher than the average stock on the market. 

Like value investing, you should carefully review a company’s fundamentals before investing in growth stocks. Learn more about completing a fundamental analysis here

Get started with growth investing

Unlike value investing, growth investing is best done when the economy is performing well (value investing is best during economic downturns). Here’s what you should consider to determine if growth investing is right for you:

  • You believe you can select winning companies in emerging industries.
  • You’re comfortable investing your money for the long-term since growth stocks take time to grow. 
  • You don’t get emotional when growth stock prices swing up and down (aka volatility). 

No matter what you decide, we don’t recommend investing solely in growth stocks. Instead, diversify your portfolio to lower your risk. You also don’t have to invest in individual stocks. Instead, you can invest in growth mutual funds or growth ETFs which allow you to invest in multiple growth stocks. 

Did you enjoy this intro to growth investing? Learn even more about investing in quality companies in Investing for Growth. This book helps you learn how to become a successful value investor, step-by-step. Check out the book here

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Elisabeth O. is an MBA graduate with a specialization in International Finance & Investments and over six years of financial writing experience. She is passionate about long-term investing to build wealth, avoids day trading and speculations, and loves a good Warren Buffet quote.