Growth Company - Explained
What is a Growth Company?
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What is a Growth Company?
An established 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.
- Note: A commonly confused concept is that of a growth-based company. In startups, a growth-based company has the objective of rapid growth at the expense of profitability.
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 years 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.