What Are Growth Stocks

A stock is considered a growth stock when it's growing faster and higher than stocks of other companies with similar sales and earnings figures. I say higher than other companies because you have to measure growth against something. Usually, you compare the growth of a company with growth from other companies in the same industry or compare it with the stock market in general. In practical terms, when you measure the growth of a stock against the stock market, you're actually comparing it against a generally accepted benchmark.

If a company has earnings growth of 15 percent per year over three years or more and the industry's average growth rate over the same time frame is 10 percent, then this stock qualifies as a growth stock. A growth stock is called that not only because the company is growing but also because the company is performing well with some consistency. Just because your earnings did great versus the S&P 500's average in a single year doesn't cut it. Growth must be consistently accomplished.

Although comparison is a valuable tool for evaluating a stock's potential, you don't want to pick growth stocks on the basis of comparison alone. You should also scrutinize the stock to make sure that it has other things going for it to improve your chance of success.

Investing classes ask their students, "What is Google?" Usually the answer is, "It's a search engine" or "It's a Web site directory." But the true answer is that Google is an advertising company. Yes, it does have a great search engine and offers great services for those who visit the Google Web site. But we can also label Google as an advertising company because that's how it makes most of its money.

When choosing growth stocks, you should consider investing in a company only if it makes a profit and you understand how it makes that profit. I know people who invested in Yahoo! because they were excited about the potential of the Internet. During 2000 and 2001, Internet companies were dropping like flies. As Internet companies failed, Yahoo's revenue fell, as well, because most of its money came from Internet companies! So even though Yahoo! made money during that bad year, its sales and profits shrank in that time frame, and its stock fell 80 percent!

Unfortunately, many investors who bought Yahoo! stock didn't know how Yahoo made money, so they couldn't have predicted that Yahoo's revenues would fall as sharply as they did. You need to know such information so that you can monitor the industry and more accurately predict whether the company you choose to invest in will continue to make money based on the likelihood that its customers, in turn, will be making money.