How to invest in growth stocks

10 November 2021 by Alexandre Demers
A calculator and a pen on a graph.

Self-directed investors who focus on growth are looking for publicly traded companies that are expected to grow strongly in the coming years. By focusing on growth stocks, investors are trying to find companies that can generate significant returns over the long term.

What is growth-oriented investing?

It is an investment strategy that involves investing in companies and anticipating a growth rate well above the average of their industry or the overall market. The main goal when investing in growth stocks is to realize considerable capital gains by reselling shares at a higher price than the initial purchase price.  Investors who follow the growth investing approach are not interested in quarterly dividend payments. Also, the vast majority of companies in the growth phase prefer to reinvest their earnings instead of redistributing them to their shareholders.

Unlike value investors, it’s not about identifying bargain companies by looking for stocks that seem undervalued relative to their intrinsic value. This approach differs significantly from the growth investment strategy.

What should you look for in growth shares?

There are a few aspects to consider when looking for a publicly traded company that could offer attractive growth potential.

  • Members of the company’s management

You need to make sure that the leaders are the most qualified candidates for the company to be successful and continue to show strong growth over the long term. Some examples of questions to ask yourself: Is the president the founder of the company? Have leaders already proven themselves with other projects in the past? Are members of management major shareholders?

  • The company's competitive advantage 

The aim is to identify whether the company has a competitive edge that can protect it from its competitors in a sustainable way. You need to understand how the company stands out from its rivals and what would make the company have better customer retention or profitability.

  • The company's target market 

You also need to know who all the customers targeted by the company are, so you know what the target market is for the company’s products/services. That way, you can determine what the factors are that are currently influencing this market and try to predict other factors that could hold back growth in the future.

How do you establish the value of growth stocks?

If you’re planning to use a growth approach to invest, you will also need to analyze the company’s financial results to determine if this is an attractive opportunity for this type of strategy. To appropriately analyze growth stocks, here are some important things to consider:

  • The history of earnings growth
    The growth rate for revenues and earnings per share in recent years allows you to check whether the company has attractive growth potential. For example, a company that has achieved an average growth rate of 15% in its earnings over a 5-year period could be seen as an attractive investment opportunity.
  • Projected 5-year growth rate
    This estimate of earnings growth comes from financial projections provided by professional analysts or directly by the company in question. Although these are only projections, and often optimistic, this data can still allow us to get a rough idea of the growth potential of the company.
  • Gross profit margin ratio
    This ratio measures the profitability of the company, compares it to competitors and assesses whether managers are handling costs well in relation to revenues. Ideally, the gross profit margin should not narrow over time.
  • Return on Equity (ROE)
    The ROE is obtained by dividing net income by equity. This ratio is used to measure the return that shareholders receive in exchange for their investment in the company. For example, an ROE that reaches 20% means that an invested dollar has managed to create 20 cents in assets.

In conclusion, it’s important to understand that growth-oriented investing is an approach that can be very profitable provided that the companies in which you have invested are as successful as you had anticipated. This strategy does have a certain amount of risk related to uncertainty about the future of growth companies that have not yet reached a certain level of maturity and financial stability. Ultimately, it’s essential to do your research to fully understand the companies you plan to invest in and try to assess their long-term potential as best as possible.

Author biography

Alexandre Demers has been an active investor since 2013 and is the founder and president of Traders 360 Inc. He has also authored the e-book “Investir à contre-courant” (Investing against the grain) and hosts the “Finance 360” podcast available free on Spotify and Apple Podcast. His goal is to make stock trading more democratic and educate the public at large about the possibilities of self-managed investments.

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The above article was written by Traders 360, an independent external firm partnered with National Bank Direct Brokerage.

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