What Is a Growth Stock?

When you invest in the stock market, the goal is to grow your portfolio — perhaps even to multiply your investment several times over. If your goal were simply to maintain your current level of wealth, then you’d be better off parking your funds in bonds or money market accounts.

But there are lots of different ways to grow that nest egg. While the borders between investing styles have always been blurry, my definition of a growth stock is simple: an investment that you expect to reward you primarily through capital appreciation — i.e., an increasing share price — as opposed to dividends. Growth stocks also tend to be more “expensive” — as measured by some common valuation metrics that we’ll go over below — than stocks that have less perceived potential for capital appreciation.

In general, the best growth stocks tend to share a few common traits:

  • Revenue growth of at least 20% over each of the past three years.
  • An identifiable moat that will protect the business.
  • A valuation above the market’s average.
  • A reasonable chance to double in market capitalization in five years.

Image source: Getty Images.

This is in opposition to the other two broad styles of investing:

  • Value investing, which also aims for stock price appreciation but focuses almost solely on valuation. Value investors seek stocks that are demonstrably under-priced.
  • Income investing, which seeks to grow a portfolio via dividends, rather than price appreciation.

Let’s dig into each one of the four traits of a great growth stock.

Revenue growth of at least 20% over each of the past three years

The basic idea behind investing in growth stocks is that you’re putting your money into companies that are, well, growing. That means the products or services they offer are becoming more and more popular every day. That type of popularity will almost always show up in a company’s revenue growth, which is why this is a key metric for growth investors.

Last year, the average S&P 500 company grew revenue by 7%. The kinds of stocks growth investors seek have grown their revenue by at least 20% in each of the past three years. In other words, their sales are growing much faster than the average company’s, and they’ve done so long enough to prove that it owes to more than dumb luck.

Disruptive companies that pioneer major advances in their industries are often extremely popular, and they can reap huge rewards for shareholders. For instance, between January 2010 and January 2013, Apple would have been a textbook growth stock: The iPhone was taking off in popularity, the iPad had just been introduced, and revenue jumped 52% per year. Over that same time frame, shares returned 155%.

Apple may not be considered a growth stock anymore — more on that below — but it’s an example almost anyone can understand. In the course of just a few years, American consumers all but abandoned flip phones and started buying tens of millions of iPhones each year. It was a hard growth story to miss.

But great growth stocks aren’t always so well-known. That’s why searching for high-revenue-growth companies can be so valuable. Veeva Systems, for instance, is building out a suite of cloud solutions that will help drug companies cut costs and streamline their operations. If you aren’t an industry insider, you’d never hear about the company. But over the past three years, its revenue has grown by 29% per year.. Not surprisingly, over the same time frame, shares have tripled in value.

It’s also worth mentioning here that growth investors should focus more on sales growth than on profit growth. That’s because many growth companies aggressively reinvest their sales back into their business to capture long-term market share. In other words, they trade short-term pain (and lack of profit growth) for long-term gain.

No stock is more emblematic of this than Amazon. Between 2011 and 2015, net profit at the company actually declined by 6%. At the same time, however, sales increased 122%. CEO Jeff Bezos was too busy reinvesting in Amazon Web Services, Amazon’s fulfillment network, and a bevy of other projects to worry about short-term profitability. And shareholders were handsomely rewarded for their trust in Bezos’ plans: From the time the 2011 annual report was released to the same time in 2015, shares of Amazon more than tripled.

An identifiable moat to protect the business

The reason growth investors pay more attention to sales growth than to profit growth is that they believe profit will eventually show up in the company’s bottom line. However, as a company’s products and services become more and more popular, it’s bound to attract competition. Without a moat — i.e, a sustainable competitive advantage — to protect the business, that profit will likely never materialize.

While moats come in many different forms, they generally fall into one of four different categories. I’ll use some well-known companies to explain how each of these moats works.

The network effect

The network effect is when each additional user of a product or service makes it more valuable. Perhaps no company enjoys the network effect more than Facebook, along with its subsidiaries Instagram and WhatsApp. The more people who join these platforms, the more appealing they are to those who have not yet joined. Currently, Facebook has 2.2 billion monthly active users. In order to match that user base, any potential competitor would have to convince one-quarter of the world’s population to join its network. And if all your friends and family members are already using Facebook, then you’re probably going to choose Facebook over an upstart with a few hundred thousands users worldwide.

But that’s not the only way the network effect can work. Let’s use Netflix as an example. On the surface, each additional subscriber doesn’t really change the viewing experience. Over time, however, more subscribers means more revenue for Netflix. More revenue means Netflix can purchase or produce more content. The more content that’s available, the better Netflix is as a product.

The network effect can create a virtuous cycle that drives a company’s revenue higher at a breakneck pace.

High switching costs

Sometimes, a company’s product becomes so integral in our everyday lives that switching to a competing product would be far too much of a hassle. For the everyday consumer, there’s no better example than banks. I’ve publicly vowed for over six months to switch away from Wells Fargo after the litany of scandals that have come to light. And yet, as of now, I still use the bank. Why? I have direct deposit set up, a number of automatic payments synced, and a business account with the bank as well. I’ll eventually get around to switching, but for now, the cost — in time, effort, and headaches — feels too high for me at the moment.

In the world of growth stocks, companies that offer software as a service (SaaS) in particular capitalize on high switching costs. In a nutshell, an SaaS company provides software that’s stored, updated, and upgraded entirely on the cloud — i.e., on an external server, rather than on the user’s server or machine.

The best example I can think of is Axon Enterprises, which used to be known as TASER International. While the company still makes its eponymous stun guns, it has branched into police body cameras. The key here, from an SaaS standpoint, is that users load, store, and analyze all of their video footage on Axon’s software platform, Evidence.com. In other words, without access to Evidence.com, they have no access to any of that content.

Now think about the switching costs involved for a police department that has been using Evidence.com for years. Not only would it have to pay to migrate all of that data, but it would have to retrain its entire workforce on a new interface and risk losing critical legal evidence in the process. The costs would simply be too high, and therein lies an opportunity for growth investors.

That’s why SaaS companies often have very “sticky” revenues: Once customers sign on, it take a herculean effort by the competition to pry them away.

Low-cost production

If there are 20 different companies that make the exact same product, but one of them offers it a lower price than all the rest, then that company will be consumers’ top choice. As a beginning investor, whenever I thought about low-cost production, I thought of physical goods. Compass Minerals, for instance, owns the largest salt mines in the world. That means it spends less money for land rights and salt extraction than anyone else on earth. This advantage allows Compass to provide rock salt, which is needed for everything from de-icing roads to developing plant nutrients, at a lower cost than the competition.

However, the advantage of low-cost production is increasingly enjoyed by providers of services, rather than producers of physical goods. Amazon, for instance, is able to offer two-day delivery for less money (via Amazon Prime membership) than anyone else thanks to its vast network of fulfillment centers.

And Alphabet‘s Google collects gobs of user data at a lower cost than just about any other service. That’s because it has seven products — its search engine, Maps, GMail, Play Store, Android, Chrome, and YouTube — with over 1 billion users each. Since the products are free — except for Play Store — they have lots of users. Alphabet collects their data at a minimal cost and then sells it to advertisers for a sizable profit.

Intangible assets

Finally, we have something of a catch-all in “intangible assets.” This includes less concrete assets such as brand value and patents.

If we look at Forbes‘ 2018 rankings of the world’s most valuable brands, the list is dominated by technology companies. Six of the top ten are in the tech industry, including Apple, Google, Microsoft, Facebook, Amazon, and Samsung.

Apple, once again, is a perfect exemplar: The halo surrounding Apple’s brand and the buzz generated by every Apple product release are the envy of nearly every company on Earth. The public’s high regard of Apple — and even rabid loyalty to it — helps to drive industry-leading sales, even though Apple products are often far more expensive than the competition.

Patents are another example of an intangible asset, and biotechnology companies are the most popular growth stocks that rely on patents. Pharmaceutical companies spend billions of dollars every year developing new drugs, but when a product obtains FDA approval and makes its way to the market, the patent on it gives the creator exclusive rights to sell it. This allows the company to recoup its investment — often many times over.

It’s worth noting, however, that patents don’t last forever, and you need to have a working knowledge of the industry if you’re going to wager your hard-earned cash on drugs that may or may not receive FDA approval.

A valuation above the market’s

While it’s not a hard-and-fast rule, growth stocks often trade at a valuation higher than the market’s. So how can you tell whether a stock is “expensive” at the moment?

The most popular measure of a stock’s valuation is the price-to-earnings (P/E) ratio, which is simply the price of a single share divided by the net income the company earned per share over the past 12 months. Right now the average stock in the S&P 500 index trades for 25 times what it has earned (per share) over the past 12 months, therefore any stock with a P/E above 25 would be considered “expensive” at the moment.

Since we’ve referenced it so many times already, let’s return to Apple as an example. Its share price as of this writing is $185 per share. Over the past year, the company has generated earnings of $10.35 per share. Rounding to the nearest whole number, that gives it a P/E ratio of 18. That means Apple stock is “cheaper” than the average stock, which is partly because investors don’t expect skyrocketing sales from the company anymore. In other words, it doesn’t look much like a growth stock right now.

Popular growth stocks often have sky-high P/E ratios — sometimes in the triple digits — for two reasons: 1) investors are willing to pay a high price for the company’s growth potential and 2) these companies tend to have low (or nonexistent) earnings because they’re investing all their revenue in expansion.

But that alone shouldn’t stop you from investing in growth stocks. Back in January 2016, for instance, Amazon had a P/E ratio of over 500, and since then the stock has more than doubled. You shouldn’t ignore a company’s P/E ratio entirely, but it should take a back seat to other variables such as the pace of revenue growth, the presence of a moat, and — our final topic — the market opportunity the company could capture.

A reasonable chance to double in size over the next five years

Because all investors are looking to grow their nest eggs, and because growth investors are focused solely on price appreciation, it’s important to gauge the stock’s potential over at least the next five years. As a rule of thumb, that’s long enough for you to profit from a company’s success and to ride out the kind of short-term volatility that’s normal in the stock market.

There are lots of ways to estimate a company’s growth potential, but perhaps the easiest way to start is to look at a company’s market capitalization. Ask yourself: “Could I really see this company doubling in size in five years?”

As a growth investor myself, I sold shares of Apple when its market cap reached about $900 billion, because I didn’t see the company being worth $1.8 trillion in 2023. And I decided to put the proceeds of the sale into smaller companies — like the aforementioned Axon, which was worth $1.2 billion when I first bought it and has since advanced to $3.6 billion.

The next most important variable to investigate is a company’s total addressable market (TAM), which, in the simplest terms, is the maximum annual revenue that a company could ever achieve. TAM is a metric that management at most growth companies likes to tout in earnings releases or investor presentations. If you check a company’s investor relations site (just type “[Company] investor relations” into Google), you can often view such presentations. Simply comparing the TAM to the company’s current sales figures will give you an idea of how large the company’s runway for growth is.

Of course, a large TAM alone doesn’t make a growth stock a worthy investment. A company needs to demonstrate strong revenue growth (as proof that its service/product works and is popular) and a moat (as proof that it can fend off competition). But if all three of those things are present, you could be looking at a monster growth stock.

When a growth stock is no longer in growth mode

Finally, just because you determine a particular stock is a “growth stock” right now, that doesn’t mean it will necessarily maintain that status as time goes on. Typically, smaller and newer companies are more likely to have a growth designation, because they still have plenty of room to grow. Meanwhile, bigger, more established companies are often thought to have little growth potential left.

Granted, that’s not always a correct assumption: Amazon, despite being an $836 billion company that was founded 24 years ago, has remained a growth stock for years because it has branched out into more industries (delivery, groceries, and cloud services, to name a few) than anyone could could have anticipated 20 years ago.

Nonetheless, the vast majority of growth stocks eventually become “value” or “income” stocks. Here are some signs that this transition is underway:

  • Sales growth has slowed below 20% per year.
  • The company’s moat is slowly eroding, and competitors are gaining ground.
  • The stock is no longer considered “expensive,” which could make it more of a “value” stock.

Apple is once again a great example. Between the company’s fiscal 2015 and 2017, revenue actually fell. That’s what happens as you capture more and more of your TAM: There’s less room to grow. The company now pays a dividend, which is appealing to income investors, and shares trade below the S&P 500’s average P/E, making it attractive to value investors as well.

A word of caution on growth stocks

There’s risk involved in any stock — but especially growth stocks. Because these are companies with “expensive” valuations, the slightest hiccup in results can lead to dramatic swings in the stock price. You need to make sure you have the fortitude to handle such volatility without selling out of panic.

Furthermore, it’s important not to over-commit to any strict investing approach, whether it’s growth, value, or income investing. While these mental models are useful when you’re getting started, they can also become a crutch.

Back in 2011, Motley Fool co-founder David Gardner had this to say on the topic:

I do not believe the world is full of “value investors” and “growth investors,” nor do I think there are “value stocks” and “growth stocks.” It doesn’t mean there is no effective use for or meaning in these terms; it simply means that I’m not using them because I believe their lack of crystalline meaning can lead to sloppy assumptions leading to potentially sloppy thinking on the part of those who may be hearing them. I’m open to anyone else using them so long as he clearly defines his terms for his listeners.

By all means, chase after those growth stocks and make sure they have the above characteristics. But don’t let these guidelines stand in the way of pursuing the investments that make the most sense for your own portfolio.

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The author(s) may have a position in any stocks mentioned.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool’s board of directors. LinkedIn is owned by Microsoft. Brian Stoffel owns shares of Alphabet (A shares), Alphabet (C shares), Amazon, Facebook, Tesla, and Veeva Systems. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Facebook, GoPro, Tesla, and Veeva Systems. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.

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