Growth investing is a strategy where investors seek companies that exhibit signs of above-average growth, even if the share price appears expensive in terms of traditional metrics. This approach is particularly appealing when preparing for the FINRA Series 7 exam, as understanding growth investing can play a crucial role in making effective investment recommendations.
Focus on Earnings Growth
Growth investors prioritize finding companies with the potential for substantial earnings expansion. These companies typically reinvest their earnings into exciting new projects and technologies instead of distributing dividends, thereby driving their growth potential.
Characteristics of Growth Stocks
- High Earnings Growth Rate: One of the primary attributes of growth stocks is a high earnings growth rate. Investors look for consistent increases in earnings, which indicate the company’s strength and potential.
- Revenue Expansion: Growth stocks are often characterized by strong sales and revenue growth, another indicator of future earnings potential.
- Market Potential: Companies with innovative products or services that could lead to substantial market penetration are prime targets for growth investors.
Example
Consider a technology firm that is pioneering a new software platform. Its revenues have been increasing by 20% year over year, and its earnings are projected to follow suit. A growth investor would value this firm based on its potential earnings growth rather than current earnings.
Valuation Metrics
Growth stocks can be assessed using specific valuation metrics that highlight their growth potential relative to their current valuation.
PEG Ratio
The PEG ratio is a critical tool for evaluating growth stocks. It is the Price-to-Earnings (P/E) ratio divided by the earnings growth rate. A PEG ratio of 1 is considered fair value, meaning the stock’s market price equates to its projected growth rate.
$$
\text{PEG Ratio} = \frac{\text{P/E Ratio}}{\text{Earnings Growth Rate}}
$$
Interpreting the PEG Ratio:
- PEG < 1: The stock might be undervalued based on its growth prospects.
- PEG = 1: The stock is valued fairly relative to its growth.
- PEG > 1: The stock may be overvalued compared to its growth potential.
Conclusion
In growth investing, identifying the right companies with high growth potential can significantly impact an investment portfolio’s success. Key factors include a thorough analysis of earnings growth and the use of valuation metrics such as the PEG ratio. Mastery of these concepts is essential for the Series 7 exam.
Supplementary Materials
Glossary
- Earnings Growth Rate: The annual rate at which a company’s earnings increase.
- PEG Ratio: A valuation metric comparing a company’s P/E ratio to its expected earnings growth rate.
Additional Resources
### Which of the following is most indicative of a growth stock?
- [x] High earnings growth rate
- [ ] High dividend yield
- [ ] Low volatility
- [ ] High market capitalization
> **Explanation:** Growth stocks are typically characterized by a high earnings growth rate, indicating potential for future growth.
### What does a PEG ratio of 0.8 indicate?
- [x] The stock may be undervalued relative to its growth
- [ ] The stock is overvalued relative to its growth
- [x] Fairly valued compared to market peers
- [ ] High risk and high reward potential
> **Explanation:** A PEG ratio less than 1 suggests the stock is undervalued given its growth potential.
### What is the primary goal of a growth investor?
- [x] Seek companies with high potential for earnings expansion
- [ ] Identify stocks with high dividend yields
- [ ] Focus on companies with stable prices
- [ ] Diversify across sectors
> **Explanation:** Growth investors look for companies that will experience significant earnings growth over time.
### How does the PEG ratio differ from the P/E ratio?
- [x] PEG includes growth expectations, while P/E does not
- [ ] P/E includes dividends, while PEG does not
- [ ] PEG measures risk, while P/E measures reward
- [ ] P/E considers market volatility, while PEG does not
> **Explanation:** The PEG ratio adjusts the P/E ratio by factoring in the growth rate, offering a more complete view of a stock's value.
### Why might a growth investor avoid high dividend-paying stocks?
- [x] Companies often reinvest earnings for growth rather than pay dividends
- [ ] High dividends lead to low stock prices
- [x] Dividends indicate slow growth
- [ ] Dividends decrease earnings per share
> **Explanation:** Growth investors seek companies that reinvest earnings into growth opportunities rather than paying them out as dividends.
### What might be a disadvantage of growth investing?
- [x] Higher volatility compared to other stocks
- [ ] Lower dividend returns
- [x] Fewer opportunities for long-term gains
- [ ] Higher transaction costs
> **Explanation:** Growth stocks often experience higher volatility, which can be a risk factor for investors.
### What does a negative PEG ratio indicate?
- [x] Negative earnings growth, potentially a bad investment
- [ ] Undervalued stock with potential
- [x] High market risk
- [ ] Immediate sell indication
> **Explanation:** A negative PEG ratio usually indicates negative earnings growth, signaling potential financial instability.
### In what market condition do growth stocks typically perform best?
- [x] Bullish market
- [ ] Bearish market
- [ ] Stable market
- [x] Volatile market
> **Explanation:** Growth stocks often perform well in a bullish market where optimism prevails and companies are expected to grow.
### What aspect of a company do growth investors prioritize?
- [x] Innovation and product development
- [ ] Stability and dividends
- [ ] Geographic expansion
- [x] Cost management
> **Explanation:** Growth investors prioritize a company’s ability to innovate and develop new products, which can drive earnings growth.
### Growth stocks often trade at what type of P/E ratio?
- [x] High P/E ratios due to earnings expectations
- [ ] Low P/E ratios due to undervaluation
- [ ] Stable P/E ratios due to risk management
- [ ] Market average P/E ratios due to competition
> **Explanation:** Growth stocks often trade at high P/E ratios as investors are willing to pay more for the expected growth.