Definition and Overview
A growth stock is a share in a company that is expected to grow its revenues, earnings, and cash flows at a rate significantly above the average rate of growth of the broader market or its industry peers, typically characterised by high reinvestment of earnings into the business rather than distribution of profits to shareholders as dividends, and by market valuations that reflect premium multiples of current earnings, book value, or cash flow justified by investor expectations of superior future performance. Growth investors purchase these stocks with the primary objective of achieving capital appreciation as the company's earnings expand and as the market continues to assign premium valuations to those expanding earnings, rather than seeking current income through dividends.
The growth stock concept stands in contrast to the value stock, which is characterised by below-average valuation multiples relative to current earnings, book value, or other fundamental measures, reflecting either temporary business challenges, cyclical earnings weakness, or market underappreciation of the company's true earning power. While value investing seeks to purchase assets at a discount to current intrinsic value, growth investing accepts premium current valuations in exchange for the expectation of rapid future value creation that will make today's high price look cheap in retrospect. Both approaches have demonstrated the ability to generate superior long-term returns under the right conditions and in the hands of skilled practitioners, and the growth versus value debate is one of the most enduring and most intellectually stimulating in all of investment management.
The growth stock universe has evolved dramatically over the past several decades, particularly with the rise of the technology sector as the dominant driver of economic value creation in the developed world. Companies including Apple, Amazon, Alphabet, Microsoft, Meta, and Nvidia have at various points represented the archetype of growth stocks, combining extraordinary rates of revenue expansion, enormous total addressable markets, powerful network effects or other competitive advantages, and business models with the potential to scale without proportional increases in cost, generating the kind of earnings trajectory that growth investors seek.
Characteristics of Growth Companies
Growth companies share a set of distinctive characteristics that distinguish them from their slower-growing peers and that drive the premium valuations at which they typically trade in the market.
High revenue growth is the most fundamental characteristic of a growth company. A company typically qualifies as a growth stock when its revenue is expanding at a rate substantially above the nominal growth rate of the overall economy, often at double-digit percentage rates annually and in some cases at much faster rates for companies in their early hypergrowth phases. The absolute level of the growth rate matters less than its sustainability and the quality of its underlying drivers. Revenue growth fuelled by genuine expansion of the customer base, increasing wallet share from existing customers, and entry into new markets represents durable and compounding growth that justifies premium valuations. Revenue growth achieved through unsustainable promotional pricing, channel stuffing, or aggressive accounting represents fragile performance that will disappoint investors when it reverses.
Large and expanding total addressable market is a critical characteristic because the size of the opportunity a company is pursuing determines how long the growth runway can extend before the business begins to saturate its market. A company growing at fifty percent annually in a market it has already largely penetrated faces rapid deceleration as it runs out of new customers to acquire. A company growing at thirty percent annually in a market it has barely touched has the potential to sustain high growth rates for many years as it continues to expand into the vast majority of its addressable opportunity. Growth investors therefore focus intensely on the size and dynamics of the markets their portfolio companies are targeting, seeking businesses with the potential for many years of sustained above-market growth before the inevitable deceleration that comes with market maturity.
Scalable business model with improving unit economics is perhaps the most important characteristic distinguishing great growth businesses from mediocre ones. A scalable business can grow its revenues dramatically without proportional increases in its cost base, meaning that as the business grows, its profit margins expand and its free cash flow grows even faster than its revenues. Software companies, digital platforms, and marketplace businesses often exhibit this characteristic because the cost of serving an additional customer is very small once the underlying platform has been built, allowing gross margins to remain high and operating leverage to produce rapid earnings growth as revenues scale. A business that must spend approximately one dollar of incremental cost to generate one dollar of incremental revenue as it grows is not scalable in this sense and will not benefit from the operating leverage that drives the most powerful growth stock returns.
Durable competitive advantage, as discussed in the Fundamental Analysis article, is the characteristic that allows a growth company to sustain its above-market growth rate and premium profitability in the face of competitive responses from existing competitors and new entrants attracted by the company's attractive economics. Network effects, proprietary technology, brand loyalty, switching costs, and regulatory barriers are among the most powerful sources of competitive protection for growth companies, allowing them to maintain their market position and pricing power even as competitors recognise and attempt to capture the value they are creating.
Reinvestment of earnings rather than dividend payment is a hallmark of growth companies, reflecting the management team's assessment that the best use of the company's capital is to reinvest it in the business at high rates of return rather than to distribute it to shareholders. A growth company that has identified multiple opportunities to deploy capital at returns on investment significantly above its cost of capital is destroying value for shareholders by paying dividends instead of reinvesting, because each dollar paid out as a dividend is a dollar that could otherwise be compounding within the business at a high internal return rate. Growth investors typically do not expect or seek dividend income from their holdings and may actually view dividend initiation by a growth company as a negative signal suggesting that management can no longer identify sufficiently attractive reinvestment opportunities.
Growth Stock Valuation
The valuation of growth stocks is one of the most challenging and most debated topics in investment analysis, because the standard valuation multiples applied to mature companies, most importantly the price-to-earnings ratio, produce results that appear extreme when applied to early-stage or high-growth companies whose current earnings are depressed by heavy reinvestment and whose future earnings potential may be orders of magnitude larger than their current reported results.
The price-to-earnings ratio, calculated by dividing the current market price by the trailing twelve months of earnings per share, is the most commonly used equity valuation multiple but is the least useful for evaluating early-stage growth companies. A company that is investing aggressively in its own growth by building out its sales force, expanding into new markets, developing new products, and establishing its infrastructure may report near-zero or negative earnings despite generating substantial and growing revenues and despite having a clear path to profitability when it chooses to optimise for profits rather than growth. Applying a P/E multiple to near-zero earnings produces a nonsensical result, and comparing the P/E of a mature company generating twenty percent margins to that of a high-growth company currently generating negative margins misses the fundamental difference in the investment proposition each represents.
The price-to-sales ratio, calculated by dividing market capitalisation by annual revenues, is more commonly used for early-stage growth companies because revenues are always positive and provide a meaningful basis for comparison even when earnings are minimal. The appropriate price-to-sales multiple for a growth company depends on the expected future profit margin profile: a company expected to achieve high future margins justifies a higher price-to-sales multiple than one expected to remain a low-margin business indefinitely, because higher margins mean that a larger proportion of each dollar of future revenue will flow through to earnings and cash flow available to shareholders.
The price-to-earnings growth ratio, known as the PEG ratio, attempts to address the limitation of the P/E ratio as a growth stock valuation tool by dividing the P/E ratio by the expected annual earnings growth rate, incorporating the growth dimension that the unadjusted P/E ignores. A company with a P/E of forty and an expected earnings growth rate of forty percent has a PEG ratio of one, which is sometimes used as a rough benchmark for fair valuation suggesting that the investor is paying one times the growth rate for each unit of earnings. A PEG ratio below one may suggest undervaluation relative to the growth expectation while a ratio above one may suggest overvaluation. The PEG ratio is useful as a simple screen but has significant limitations including its dependence on the accuracy of the earnings growth forecast and its failure to account for differences in the quality, sustainability, and risk of growth across companies.
Discounted cash flow analysis applied to growth companies requires forecasting revenues, margins, and free cash flow over an extended explicit forecast period, often ten to fifteen years or more, to capture the full value of the growth trajectory, followed by a terminal value that represents the value of the stabilised business in perpetuity. The sensitivity of growth stock DCF valuations to the assumptions about revenue growth rates, long-term margin profiles, and discount rates is extreme, making it essential to test a wide range of scenarios and to use the DCF as a framework for structured thinking rather than as a calculator of a precise intrinsic value. Small changes in the assumed long-term growth rate or discount rate can produce valuations that differ by fifty percent or more, reflecting the enormous leverage that these inputs have on the present value of cash flows that will not materialise for many years.
The Growth vs Value Debate
The intellectual debate between growth investing and value investing is one of the most enduring in investment management, with compelling arguments and supporting evidence on both sides and with the relative performance of growth and value strategies alternating across different market environments and time periods.
Value investing, in the tradition of Benjamin Graham, argues that the most reliable path to superior long-run investment returns is to purchase securities at a significant discount to their intrinsic value, providing a margin of safety that protects against estimation error and adverse developments. Value investors focus on current earnings, book value, free cash flow, and other measures of current economic output, seeking stocks that are priced below what the fundamental analysis of these current metrics would suggest is their fair value. The long-run empirical evidence on the value premium, first systematically documented by Fama and French, shows that stocks with low price-to-book and price-to-earnings ratios have historically generated higher returns than stocks with high multiples over long periods across multiple markets.
Growth investing argues that the most reliable path to superior returns is to identify exceptional businesses with durable competitive advantages and long growth runways early in their development and to maintain ownership through the full duration of the growth phase, accepting high current valuations in exchange for the expectation of outstanding earnings growth that will make today's price look inexpensive in retrospect. The long-run track record of successful growth investors including Philip Fisher, Peter Lynch, and Stanley Druckenmiller demonstrates that exceptional growth companies maintained for extended periods can generate returns that substantially exceed those achievable through value-oriented approaches.
The empirical performance of growth versus value strategies varies significantly across market environments. Value strategies have historically outperformed during periods of economic recovery from recession, when depressed earnings of value companies normalise and when the relative attractiveness of value-priced assets is most apparent. Growth strategies have historically outperformed during periods of declining interest rates, because the high duration implicit in growth stock valuations means they benefit disproportionately from rate declines, and during periods when the market becomes increasingly willing to pay up for the scarcity of exceptional growth.
The decade following the 2008 financial crisis was one of the most extended periods of growth stock outperformance in modern market history, driven by persistently low interest rates that increased the present value of distant future earnings, the extraordinary dominance of technology platforms that generated exceptional and accelerating growth, and an investment environment that rewarded scalable, asset-light business models with premium valuations. The subsequent rise in interest rates beginning in 2022 produced a significant reversal in the relative performance of growth and value, as higher discount rates reduced the present value of the distant future earnings on which growth stock valuations depend, demonstrating the sensitivity of growth stock valuations to the interest rate environment.
Growth Investing in Practice
Growth investing in practice requires a distinctive set of analytical skills, temperament, and portfolio management disciplines that differ meaningfully from those required for value investing.
Identifying truly exceptional growth companies early in their development, before the market has fully recognised their potential and awarded them premium valuations, is the most valuable skill in growth investing and the one that produces the most spectacular long-run returns. This requires the ability to identify large markets that are ripe for disruption, to assess the quality of the business model and the sustainability of competitive advantages, to evaluate the quality and ambition of the management team, and to make judgements about the probability of eventual market leadership that require confidence in the face of uncertainty that many investors find uncomfortable.
Holding through volatility is one of the most practically difficult aspects of growth investing. The premium valuations at which growth stocks trade make them particularly sensitive to any disappointment in growth trajectories, earnings quality, or macro conditions that raise discount rates, leading to sharp price declines that test the conviction of even experienced growth investors. A growth company that misses its quarterly revenue estimate by a small percentage may see its stock decline by twenty or thirty percent in a single day as the market reassesses the growth trajectory and P/E multiple simultaneously. The ability to distinguish between a temporary setback in an otherwise intact growth story and a fundamental deterioration in the business's competitive position or growth prospects is a critical skill that separates successful growth investors from those who buy and sell at the worst possible moments.
Selling discipline is a dimension of growth investing that receives less attention than the analytical framework for identifying great growth companies but that is equally important for achieving superior returns. The temptation to hold a great growth company indefinitely, never selling regardless of how expensive it becomes relative to any reasonable fundamental scenario, has led many growth investors to give back enormous accumulated gains when growth eventually decelerates and multiples compress. Developing and maintaining a disciplined framework for evaluating when a growth stock's valuation has become so stretched that the expected future return no longer compensates adequately for the risk of holding is an essential component of a successful growth investing process.
Growth Stocks and Interest Rates
The sensitivity of growth stock valuations to changes in interest rates is one of the most important practical relationships for investment professionals to understand, because it explains much of the variation in growth stock relative performance across different market environments.
Growth stocks have high implicit duration relative to value stocks because a larger proportion of their total value is represented by earnings and cash flows that will not be realised until many years in the future. Just as a long-duration bond is more sensitive to interest rate changes than a short-duration bond, a growth stock whose value is concentrated in distant future earnings is more sensitive to changes in the discount rate than a value stock whose value is concentrated in current earnings.
When interest rates rise, the discount rate applied to future earnings increases, reducing the present value of those distant future earnings and therefore reducing growth stock valuations more sharply than the valuations of companies whose earnings are concentrated in the near term. Conversely when interest rates fall, the reduced discount rate increases the present value of distant future earnings, providing a disproportionate boost to growth stock valuations. This relationship explains why growth stocks dramatically outperformed value stocks during the period of persistently low and declining interest rates following the 2008 financial crisis, and why they dramatically underperformed when interest rates rose sharply in 2022.
Understanding this duration-like sensitivity of growth stock valuations to interest rate changes allows investment professionals to anticipate the directional impact of monetary policy changes on the relative attractiveness of growth versus value equity strategies and to position client portfolios accordingly within their overall asset allocation framework.
Growth Funds and Indices
For investors seeking exposure to growth stocks through pooled vehicles rather than individual stock selection, a wide range of actively managed growth funds and passively managed growth indices are available across the full spectrum of market capitalisation and geographic scope.
The Russell 1000 Growth Index and the S&P 500 Growth Index are the most widely followed benchmarks for US large-cap growth equity, each constructed using a combination of valuation metrics and growth metrics to classify the universe of large-cap stocks into growth and value subsets. The MSCI World Growth Index and the MSCI Emerging Markets Growth Index provide analogous benchmarks for international and emerging market growth equity respectively.
Actively managed growth funds seek to outperform these benchmarks through superior stock selection, applying the analytical frameworks described above to identify the highest quality growth companies trading at the most attractive valuations relative to their growth prospects. The track record of actively managed growth funds relative to their passive benchmarks is mixed, consistent with the general finding that most active managers underperform their benchmarks over long periods after fees, though the greater dispersion of returns in the growth segment of the market and the more pronounced information asymmetries in less well-covered growth companies may provide somewhat more opportunity for skilled active managers to add value than is available in more efficiently priced large-cap value strategies.
Examination Relevance and Key Takeaways
Growth stocks are tested on the Series 65 examination in the context of equity investment strategies, portfolio construction, valuation, and the comparative assessment of different investment approaches. Candidates must understand the definition and key characteristics of growth stocks including high revenue growth, large total addressable markets, scalable business models, durable competitive advantages, and reinvestment of earnings rather than dividend payment, the distinctive valuation challenges of growth companies including the limitations of the P/E ratio and the greater utility of price-to-sales, PEG ratios, and DCF analysis for early-stage and high-growth businesses, the growth versus value debate and the conditions under which each approach tends to outperform, and the sensitivity of growth stock valuations to changes in interest rates reflecting their high implicit duration.
The core points to retain are these: growth stocks are shares in companies expected to grow revenues and earnings significantly faster than the market average, typically trading at premium valuations reflecting high future expectations; key characteristics include high revenue growth, large total addressable markets, scalable business models with improving unit economics, durable competitive advantages, and reinvestment of earnings rather than dividend payment; growth stock valuation relies less on P/E ratios and more on price-to-sales ratios, PEG ratios, and long-horizon DCF models because current earnings are often depressed by heavy reinvestment; the growth versus value debate reflects different theories about the primary driver of superior long-run investment returns with value emphasising current asset cheapness and growth emphasising future earnings power; growth stocks have historically outperformed during periods of declining interest rates and underperformed during periods of rising rates reflecting their high implicit duration; and the most practically challenging aspects of growth investing are identifying truly exceptional companies early in their development, holding through the inevitable volatility of premium-valued stocks, and maintaining disciplined selling discipline when valuations become disconnected from any reasonable fundamental scenario.
