“Is growth investing a good way to grow wealth in the stock market?”

Undeniably, the answer is yes. Many have increased their net worth though this style of investment – but many more are likely to have failed. Understanding what growth investing is will make a difference between success and failure.

Growth stocks can be categorised according to their financial results, as follows:

1. Highly profitable stocks

These deliver consistent and rapid growth in revenue, profit and operating cash flow for a company. Unlike dividend stocks, earnings are put back into the business for further expansion, and shareholders receive little, if any, dividends.

2. The breakevens

This type of growth stock is popular in the United States and tends to report rapid growth in sales and gross profits, as well as even larger growth in marketing and research/development expenses.

The company, therefore, reports either low profits before tax or even small losses.

These types of growth stocks are nevertheless vital to certain firms because they increase the market share of their goods and services; develop and innovate their output to remain relevant; and reduce tax payments to the US government.

3. The cash suckers

This kind of growth stock is able to grow its base of users and sales rapidly but remains unprofitable. The company would constantly need to raise funds to stay afloat.

Valuation tools for growth stocks

1. Compound annual growth rate (CAGR)

CAGR computes the growth rate of a stock’s client base, revenues and profit figures, such as gross profits and shareholders’ earnings over a period annually.

2. Price/earnings-to-growth ratio (PEG ratio)

This compares the stock’s current price and earnings ratio with its growth rate. If A1 Bhd has a P/E ratio of 30 and has an earnings growth rate of 30% a year, then its PEG ratio is 1.0.

3. Price-to-sales ratio (P/S ratio)

This is calculated by dividing a stock’s market capitalisation with its sales for the last 12 months. If a stock’s market capitalisation is RM50 billion and it recorded RM10 billion in the last 12 months, it has a P/S ratio of 5.0.

4. Price-to-operating cash flow ratio (P/OCF ratio)

P/OCF Ratio is calculated by dividing a stock’s market capitalisation with its cash flows from operations in the past 12 months. If a stock has RM50 billion in market capitalisation and delivered RM5 billion in cash flow over the last 12 months, its P/OCF ratio would be 10.0.

Investors can use these formulas to compare different growth stocks.

Do growth stocks always go up?

Prices of growth stocks go up and down as with any other stocks. They can also be more volatile than dividend stocks, as there are more people who are trading or investing in these stocks in the market.

This is because growth stocks are seen to be more exciting than dividend stocks, with bigger and faster capital gains. Prices of these stocks could rise rapidly when the market is optimistic, or tumble just as quickly if the market is pessimistic.

This article first appeared in KCLau.com.

Ian Tai is a financial content writer, dividend investor, and author of over 450 articles on finance featured in KCLau.com in Malaysia, and ‘Fifth Person’, ‘Value Invest Asia’ and ‘Small Cap Asia’ in Singapore. He is a regular host and presenter of a weekly financial webinar in KCLau.com.