Growth Stock Performance

Earnings Growth

• The primary driver of a growth stock's price appreciation is earnings growth. The faster a company increases its earnings, the more its stock can appreciate. For example, XYZ's earnings increase 30 percent per year. Last year it earned $1 per share. At $30 per share, XYZ has a price-to-earnings ratio of 30. This year XYZ earns $1.30. At a P/E of 30, the price of XYZ stock advances to $39. ABC's earnings increase 15 percent per year. Last year, it earned $2 per share -- twice as much as XYZ. The rule of thumb is that in a fully valued stock, the P/E roughly equals the earnings growth rate, so at a P/E of 15, ABC also trades at $30 per share. This year, ABC earns $2.30 per share and its price increases to $34.50. Assuming that XYZ and ABC earnings growth rates and P/Es remain constant, XYZ will more than double in price in three years to $65.91, while ABC will appreciate about 50 percent to $45.62.
  
  

P/E Expansion

• P/Es are not static. Other factors being equal, a stock's P/E can change with changing market conditions and investor sentiment. Generally speaking, the faster a company grows, the higher its stock's P/E can rise. If XYZ's earnings increase 30 percent annually, its P/E can expand to 40, 50 and even 60, whereas ABC's P/E will most likely remain much lower, in the 15 to 20 range. P/E expansion means increasing stock price.
  
  

Price Fluctuation

• Growth stocks tend to fluctuate more in price compared to other types of stocks, reflecting a wider range of emotions and opinions about them.
  
  

Getting Ahead of Themselves

• Growth stocks do not rise in a straight line. Their ascent resembles a staircase. They experience an advance, a pullback or consolidation, then another advance. Investor enthusiasm often pushes a growth stock too far up to unsustainable levels so it eventually must give back some of the gains, falling back for a period of time, which is called a correction.
  
  

Typical Lifecycle

• A small young company with a new exciting product might experience a period of explosive growth as businesses and consumers worldwide buy its products and the company expands into new markets and areas. The rapid advance of the stock reflects the rapid growth. But every market is finite and eventually becomes saturated. Competition can introduce new or better products, and the growth slows. Growth investors are unkind to former leaders and typically sell them at the first sign of trouble. The stock drops suddenly and precipitously. Some companies find new ways to grow while others experience a drop in sales. The stock which is by then well known for its past performance sputters, churns and eventually goes into decline.