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Ask any investors why they bought a particular stock, and a good number of them will reply with something along the lines of, "because it is moving well." This is not entirely incorrect, since growth is one of the main reasons for buying a stock and seeing good returns. The problem is that people mix "growing" with "a good Growth Stock" and end up overpaying for the promise of future earnings.
This article aims to tell you what makes a Growth Stock, the risks involved, and the tax implications on such investments.
Key Takeaways
- Growth Stocks typically trade at a higher P/E ratio than the overall market, usually due to higher expectations of future earnings.
- Growth in revenue and profits must be sustainable for the stock to deliver value. Not all revenues, even growing ones, translate to profits.
- Position sizes are more important in Growth Stocks than anywhere else in investing.
- Interest rates impact Growth Stocks more than other stocks do. Since Growth Stocks are valued on future earnings, any change in interest rates will impact them more than other stocks.
- In India, selling a listed Growth Stock within 12 months versus after 12 months can mean the difference between a 20% tax rate and a 12.5% rate on your gains, which is worth factoring into your exit plan, not just your entry decision.
What Makes Stock ‘Growth Stock’?
There is no hard and fast definition of what constitutes a "Growth Stock." These are stocks of companies with revenues and profits growing consistently faster than the overall market or a specific sector they belong to and have a significantly higher P/E multiple than comparable firms.
Another way to think about it is that compared to value or dividend stocks, Growth Stocks reinvest most or all their profits back into the business and are less concerned with current earnings.
Value stocks are discounted by the market and have lower P/E ratios compared to Growth Stocks, while dividend stocks tend to have similar earnings growth rates to Growth Stocks, but a significantly higher proportion of profits paid out as dividends to shareholders.
These categories are not set in stone, and most companies can transition from one category to another over time depending on their stage in the business cycle.
A company that used to be a Growth Stock can become a dividend stock if it reaches a stable earnings trajectory.
Dividend stocks can also turn into Growth Stocks if the company begins to reinvest significantly more profits back into the business to fuel future earnings power.
Also Read About: What is growth investing?
Growth vs Value vs Dividend Stocks: A Quick Look at How They Are Different
| Feature | Growth Stock | Value Stock | Dividend Stock |
| Typical valuation | High P/E relative to peers | Low P/E relative to peers | Moderate, stable |
| Profit use | Reinvested in the business | Varies | Paid out as dividends |
| Investor's main bet | Future earnings expansion | Market correcting mispricing | Steady, reliable income |
| Volatility | Usually higher | Usually moderate | Usually lower |
How to Invest in Growth Stocks?
Growth Stocks should only be a part of one's overall allocation and not a larger investment theme or strategy. It is important to adhere to this allocation discipline in all subsequent Growth Stock purchases.
Decide on a reasonable allocation upfront, rather than letting it grow organically because a few positions have done well and now dominate your portfolio by accident.
Diversify across sectors within your growth allocation, since concentration in a single theme, however compelling the story, is exactly the kind of risk that hurts most when it turns.
Revisit the original thesis periodically. If the reason you bought a stock (a specific product cycle, market expansion, or margin improvement) has already played out, the stock may simply no longer be a Growth Stock in your portfolio, whatever its share price does next.
Accept volatility as the price of admission. Growth Stocks will have periods of sharp drawdown even when the underlying business is performing well. Reacting every dip defeats the purpose of holding them in the first place.
How to Evaluate Growth Stock?
- Look at projected revenue and profit growth
When assessing a Growth Stock, it's important to look not just at the most recent earnings report or revenue figure, but the trajectory of revenues and profits over several years. One strong quarter or year of performance is seldom indicative of long-term trends. - Understand the source of growth
Assessing whether a company is growing due to expansion in revenues, margins, or profitability is crucial in understanding if the stock is a good growth investment. Similarly, understanding whether that growth is due to expansion in the existing customer base or entirely due to higher spending per customer is important. - Check balance sheet, not just income statement
Since Growth Stocks typically require funding from somewhere, it's important to understand if the money is being generated from operations, through dilution, or through increased leverage. Each has drastically different implications for the growth prospects of the company and the current shareholders. - Compare valuation to growth rates
Since Growth Stocks have a significantly higher P/E, it's important to compare valuations to growth rates and not to the broader market or similar stocks. A stock with a P/E of 40 could be reasonably valued if its profits are growing at 35% annually, while the same multiple on a stock with 12% annual profit growth is significantly rich. This is effectively the reasoning behind the PEG ratio (Price-to-Earnings-to-Growth).
Monitor management projections over time. It helps to track management's projections for the stock's performance and growth in revenues and profits several years out and compare it to what happens. Realistic, careful management is often a better indicator of a good Growth Stock than aggressive proclamations.
Risks Associated with Growth Stocks
Growth Stocks are higher risk, higher reward securities.
The primary risk associated with Growth Stocks is that of valuation compression due to lower-than-expected earnings growth.
There is also execution risk, wherein the company fails to meet its earnings projections due to various factors beyond the control of management.
The potential for such risk is higher for young, untested management teams.
Growth Stocks are also subject to concentration risk because of their tendency to cluster in specific sectors like technology and internet services.
Finally, most Growth Stocks require a long-time horizon before delivering value. Many investors fail to account for this, selling off their investments prematurely during a downturn.
Does SEBI Regulate Growth Stocks?
While SEBI does not specifically regulate or dictate what Growth Stocks are, there are still several relevant considerations for potential investors.
- Mutual fund categorisation: Schemes must explicitly declare their investment style (growth, value, or blend) in Scheme Information Documents.
- Small and Mid-cap exposure: Growth companies frequently reside in mid and small-cap segments, which carry higher Risk-o-meter ratings.
- LODR disclosures: Listed growth firms must promptly disclose material business updates, product launches, or major contracts that influence future earnings expectations.
Taxation on Gains from Growth Stocks
The taxation of gains from Growth Stocks is straightforward and follows the standard capital gains tax rules.
Long-term capital gains tax applies for shares held for more than 12 months, while gains from shares held for 12 months or less are classified as short-term gains and taxed at a flat rate of 20%.
The long-term capital gains tax rate in India is 12.5%, with a ₹1.25 lakh exemption under section 112A for eligible equity shares.
Example: If an investor buys equity shares for ₹10 lakh and sells them later the same year for ₹12 lakh, they will incur a ₹2 lakh short-term capital gain and pay ₹40,000 in taxes. On the other hand, if an investor holds onto the ₹10 lakh share for 15 months and sells it for ₹12 lakh, they will incur a ₹2 lakh long-term capital gain. After the ₹1.25 lakh exemption under Section 112A, the taxable gain is ₹75,000, resulting in ₹9,375 in taxes at the 12.5% rate.
Points to consider:
Securities Transaction Tax (STT) applies to delivery trades executed on recognised stock exchanges at 0.1% on delivery-based equity transactions, whereas off-market trades do not attract STT but carry different capital gains compliance checks.
The ₹1.25 lakh annual exemption applies to eligible long-term capital gains covered under Section 112A. It is calculated on the aggregate eligible gains, not on a per-share basis.
Since most Growth Stocks tend to be volatile, the likelihood of selling them before the 12-month mark increases dramatically, thereby pushing the gains on sale into the higher short-term tax bucket. The best way to avoid this is to have a clear idea of one's intended investment horizon from the get-go.
Dividend taxation affects Growth Stocks minimally as they rarely pay out earnings. When paid, dividends are taxed directly in the hands of the investor at their applicable income tax slab rate, with TDS applicable if annual payouts exceed ₹10,000.
While none of it should be the deciding factor when purchasing a Growth Stock, tax considerations, particularly the short-term capital gains tax, can be an important consideration when determining the sale price of a stock.
Conclusion
A Growth Stock is essentially an investment in a company's future earnings power. The most important difference between a Growth Stock and an otherwise similar-looking company with promising fundamentals, but no future earnings growth is its current and projected earnings trajectory. When selecting Growth Stocks for investment, it's important to consider the position size, potential valuation risks, sensitivity to interest rates and, for Indian investors, tax considerations.
Also Read About: What is Value Investing?
