Growth Company Definition
A growth company is an industry leader that is typically associated with significant positive cash flows and earnings that grow exponentially at rates far exceeding the industry average. Growth companies rely on innovative products or services to create an expanding as well as sustainable customer base, while at the same time generating lucrative reinvestment opportunities for its own retained earnings. Share prices of publicly traded growth companies usually increase rapidly, in spite of such companies paying little to no dividends to investors. The absence of dividends is mostly due to the fact that growth companies usually choose to inject all or a significant proportion of their profits back into the business to maintain the high rate of growth. However, this attribute renders growth companies unattractive to most income investors.
A Little More on What is a Growth Company
Growth companies are usually young companies, mostly ones that belong to the technology sector. Google is a shining example of a growth company — the multinational technology company went public via an initial public offering (IPO) on August 19, 2004, just six years after its launch in 1998. Google’s transition into a publicly-traded entity was a resounding success; its shares more than quadrupled in the days following the IPO — a feat that was attributed to an exponential rise of its stock market capitalization. At present, Google is considered one of the hallowed Big Four technology companies, the others being Amazon, Apple and Facebook.
Defining Attributes of Growth Companies
- A defining characteristic of growth companies is that their shares almost always receive extremely high valuations in the stock market. This is because the market expects such companies to consistently turn in higher profits in the future, especially when compared to mature firms that typically turn in stable earnings with no discernible growth in profits.
- Another characteristic of growth companies is that they tend to grow at rates that far exceed the growth rate of the overall economy. However, in spite of the high free cash flow, such companies seldom pay dividends, opting instead to spend their profits on research and development. Therefore, although growth stocks ( i.e. stocks issued by growth companies) are typically unattractive to income investors, they are widely sought by growth investors.
- When evaluated using conventional valuation metrics such as price-to-earnings, growth stocks typically command prices that are several times higher than average. For example, when a regular value stock is currently valued at around 10 times its earnings for the past year, a growth stock can fetch prices that are up to 50 – 60 times of its past year earnings. Such ambitious valuations are a result of the collective sentiment of investors that display high optimism for the profit potential of growth stocks.
- Growth stocks tend to outperform value stocks during bullish markets because of perceived lower risk levels prevalent in the markets. As such, growth stocks are preferred by investors when the markets are optimistic. On the other hand, when the markets are bearish, growth stocks tend to underperform value stocks. This is because of dwindling sales growth owing to weaker economic activity during such a period.
- While growth stocks are ideally much more lucrative investment instruments compared to their more conservatively valued peers, they are also much riskier. The primary cause of this risk is the pricing gap — since growth stocks tend to fetch prices as high as 60 times the past year’s earnings, they can also potentially fall at the same rate and at the slightest operating mistake. Such a fall in valuation will be exponentially higher for growth stocks when compared to a traditional discounted stock.
Things to Consider when Purchasing Growth Stocks
Any investor seeking to invest in a growth company should watch out for certain trends associated with growth stocks. Some of these trends are listed below.
- Not all companies that are growing at exponential rates are “growth companies”, nor are their stocks “growth stocks”. As such, despite their current growth curve, such stocks may not be good investment opportunities.
- Extraordinarily strong sales and surging revenue are usually good indicators of attractive growth stocks, but they are not comprehensive.
- More often than not, a growth stock will have a much smaller market capitalization during its initial stages of expansion, but will start growing exponentially after it achieves scale.
- While many investors choose to disregard growth stocks due to their unattractive short-term earnings results, such stocks usually have a huge potential for massive sales and profit gains in the future. Nevertheless, it is vital, even for a growth company, to display some positive signs that its business can generate profits in the foreseeable future.
- Gross profit margin is a great indicator of a growth company’s pricing power. Companies such as Apple are able to consistently charge higher prices for their products than their peers in the industry.
- Since growth companies reinvest their profits into the business at a highly disproportionate rate, they often fall short on their operating margins. As such, growth companies need to have plans in place to reach sustainable operating profitability.