Growth stock
Also written Growth stocks · Growth share · Growth company stock
A share the market expects to grow faster than its peers — typically high P/E, high P/B and low dividend yield, bought for capital gain rather than income.
In plain language
Stocks are often sorted into two families for portfolio work: growth and value.
The simplest test uses three ratios. A growth stock has a high P/E, a high P/B and a low dividend yield. A value stock is the mirror image — low P/E, low P/B, high dividend yield.
Why would anyone pay a high price for a rupee of today's earnings? Because they expect tomorrow's earnings to be much larger. The price reflects a future the company has not delivered yet.
The low dividend fits the same story. Profit is being ploughed back into the business instead of paid out.
Note what the label is not. It is not a judgement that the stock is a good buy. It is a classification, and it can change.
How it works
The ratio test (Chapter 12, section 12.5.3). There are many ways to sort stocks into growth and value. One popular way uses P/E, P/B and dividend yield: stocks with low P/B, low P/E and high dividend yield are categorised as value stocks; stocks with high P/B, high P/E and low dividend yield are categorised as growth stocks. Style indices are built on this split so that growth and value portfolios can be benchmarked.
What a growth company looks like (Chapter 18, section 18.8.1). High future earnings or profit growth; a monopolistic or niche product or service with high market share; low dividend yield or pay-out because profits are reinvested to fuel growth; a higher valuation than peers; a higher risk parameter than peers; and early-stage companies. Section 18.8.1.1 adds the screeners used to find them — growth of historical revenue and earnings, forecast growth, and the industry growth rate, taken annually and quarterly year on year.
The label migrates. Section 12.5.3 notes that style indices have much higher turnover than broad market indices, precisely because valuation ratios change over time and stocks frequently migrate from one style category to another on reconstitution dates. Section 18.8.1 makes the same point about the companies themselves: a company categorised as growth today will over time attain steady-state growth.
A side effect inside an index (Chapter 12, section 12.3.1). The workbook uses growth stocks to explain the downward bias of a price-weighted index: high-growth stocks tend to have higher prices, and because such stocks tend to split, the stocks of growing companies consistently lose weight within that kind of index.
No cut-off is given. The workbook sets no P/E, P/B or dividend-yield level at which a stock becomes a growth stock. The test is relative — high or low against the rest of the universe.
A worked example
Illustrative figures. A manager sorts three listed companies using the workbook's three ratios before allocating Rs 30,00,000.
| Ratio A Ltd | Ratio B Ltd | Ratio C Ltd | |
|---|---|---|---|
| P/E | 46 | 11 | 22 |
| P/B | 9.5 | 1.1 | 3.0 |
| Dividend yield | 0.2% | 5.4% | 1.8% |
| Classification | Growth | Value | Neither clearly |
Ratio A Ltd is the growth stock on all three tests. Ratio B Ltd is the value stock on all three.
The manager puts Rs 18,00,000 into A and Rs 12,00,000 into B — a blend.
Now run the income arithmetic, because this is where the label bites. On Rs 12,00,000 of B at a 5.4% yield, the portfolio receives about Rs 64,800 of dividend a year. On Rs 18,00,000 of A at 0.2%, it receives about Rs 3,600. A growth holding of one and a half times the size delivers one-eighteenth of the income. Everything A is expected to give comes as price appreciation, which means it arrives only if the growth arrives.
Two years on, A's earnings have doubled while its price has risen 40%. Its P/E is now 32 and its dividend yield has crept up. On a reconstitution date it may no longer qualify for the growth index at all.
Why NISM asks about it
Chapter 12 (Introduction to Indices), section 12.5.3 (Style Indices), gives the three-ratio classification and is the section most likely to be examined directly — a question naming high P/E, high P/B and low dividend yield and asking what such a stock is called. Section 12.5.4 extends it to capitalisation-and-style segments such as large cap growth and mid cap growth.
Chapter 18, section 18.8.1, supplies the company characteristics and the screens. Chapter 12, section 12.3.1, uses growth stocks in its explanation of the downward bias of a price-weighted index — an easy question to miss because it sits in the index-construction material, not the styles material.
Common exam traps
- High P/E means growth, not overvalued. A growth stock may or may not be an overvalued security; the ratio test is a classification, the SML test is a valuation judgement. Two different ideas.
- Low dividend yield is a growth marker. Candidates associate low yield with a bad stock and reverse the classification.
- All three ratios point the same way. High P/E and high P/B and low dividend yield. A stock with a high P/E and a high dividend yield fits neither box cleanly.
- Stocks migrate between style categories, which is why style indices turn over more than broad ones. The label belongs to the stock at a point in time.
- Do not confuse a growth stock with growth investing in the private equity sense — a minority stake in an unlisted company, from a different paper.
Where this is taught
Free preparation for NISM Series XXI-BRelated terms
- Market capitalisation bandsSEBI's rank-based bands for classifying companies by size — large cap is the 1st to 100th company, mid cap the 101st to 250th, small cap everything from the 251st onward, by full market capitalisation.
- Style indexAn index of value stocks (low P/E, low P/B, high dividend yield) or growth stocks (the reverse), built to benchmark style managers — with far higher turnover than broad market indices.
- Downward biasA weakness of price-weighted indices: high-growth stocks that split to keep their price accessible steadily lose index weight, so the index understates the return of its best-performing constituents.
- Fundamental P/EThe P/E ratio implied by the dividend discount model — derived from a firm's payout ratio, required return and expected dividend growth rather than observed from the market price.
- Growth investment styleAn active equity style that buys companies expected to grow faster than their peers, accepts a premium valuation for them, and aims at capital gain rather than income.
- Value investment styleAn investment management style of buying stocks priced below their intrinsic value, on the belief that the market has mispriced them and will correct that mispricing over time.
- Value stockA stock classified, typically for index and benchmarking purposes, as cheap relative to its fundamentals — low price-to-book, low price-to-earnings and high dividend yield being the workbook's own ratio criteria.