Why do people invest in the stock market? To try to earn a profit, of course! But there are different ways to go about that.
Some investors look for companies that are long-time safe havens — you buy your shares, the company grows dependably, and it rewards its shareholders with a portion of its earnings now and then.
Other investors look for companies that are on the cusp of breaking it big, generating a massive gain in share value in a relatively short time.
We identify these two kinds of commodities as dividend and growth stocks. Which type are you more suited for? Gorilla Trades takes a closer look at each.
Dividend stocks are those that pay out a part of a company’s earnings directly back to shareholders, usually quarterly. As long as a stockholder keeps their position in the stock before a deadline (called the ex-dividend date), they’ll receive a certain percentage of their share as a bonus payment.
Dividends are paid out in the form of cash payments or added stock shares. In most cases, shareholders have the choice to forego the cash payments and reinvest instead.
Most companies that issue dividends are large, established corporations with a proven track record of consistent success. We’re talking industry titans like Apple, Microsoft, Pepsi, 3M, Chevron, Verizon, Exxon Mobil, and Walmart.
The list of dividend stocks also includes some companies that aren’t exactly household names (Crown Castle International or Antero Midstream, anyone?), but quietly dominate the market share of the industries they represent.
Why do these companies issue dividends? Essentially, it’s a way to give their loyal shareholders an opportunity for profit beyond the normal course of business, something like a bonus “thank-you” gift for sticking with them.
Paying out dividends is also an indicator of reassurance that the company’s doing well, keeping up a predictable cash flow pattern over extended periods of time.
However, that consistency in value works both ways: While you’ll probably never incur giant losses in a dividend stock’s share value, you likely won’t see explosive growth.
Dividend payouts are earnings that the company is essentially giving away — it’s not coming back or being reinvested. So a company’s share value may go down a little bit when dividend season arises.
Start-up companies seldom issue dividends (for reasons we’re about to explore). Furthermore, most companies that are still in their early or middling stages of growth aren’t in a position to issue dividends, especially if they’re targeting a period of extensive growth or expansion.
Growth stocks are, for all intents and purposes, the opposite of dividend stocks. They represent companies expecting to have earnings rates that exceed the overall growth of the stock market.
Companies that are considered growth stocks don’t issue dividends because they’re focused on building their business. Most (if not all) of their retained earnings go toward reinvesting in their businesses — expansion projects, research and development, ramping up marketing efforts, recruiting and paying employees, and so forth.
Growth stocks are usually start-ups, early-stage, and mid-stage companies. But it takes a little more than that classification to be considered to be a true growth stock. The company must have several factors that point to high growth potential.
For example, a growth stock company might have a fervent and loyal customer base that brings in a consistent amount of revenue. They might offer a popular niche product or service that no other company in the world does at the moment. Alternatively, they might have captured a large share of the market of their business that they’re able to hang onto for an established time.
True growth stocks usually cost a little more than other commodities, as clued-in investors will seek to buy into them at a price point that’s still affordable. This drives share prices up.
Growth stocks also experience value increases when the overall economy is improving. When people are spending more money in general, they’re more apt to spend it on the goods and services growth stocks supply. Consumers are a little more adventurous when the economy’s in good shape, so they’ll take chances on new things.
However, growth stock shareholders only realize profits when they sell their shares. Since they don’t take part in the retained earnings as dividend shareholders do, they have to wait until the commodity’s value has increased enough to generate a profit.
The implication of a growth stock is that the time frame should be a little shorter. Growth stocks come at high risk, but the rewards can be high, as well.
Strictly speaking, every commodity on the stock market was a growth stock at one point. Amazon was a growth stock in the late 1990s. Everyone who had faith in Amazon and held onto their shares long enough saw a huge profit in an unusually short time. But realize that Amazon was something of an anomaly in this regard — many growth stocks will take a little longer to see gains materialize. Many won’t get there at all.
Analysts use several metrics to determine a stock’s potential. Especially when you’re looking for growth stocks, there are a few common indicators that can show where a company is headed. All of them should be considered concurrently.
EPS is one of the most important data points in evaluating the prospects of both growth and dividend stocks. It’s a simple calculation of the company’s net income divided by the number of outstanding shares. The more shareholders are earning, the better the chances of more immediate growth.
If a young or medium-sized company’s EPS has grown by at least 25% over the course of the last year, it’s a fairly good sign that demand for the company’s products or services is on the rise. If that company can sustain growth for a consecutive number of quarters or years, that’s even better.
P/E is another data point that’s popular in comparing growth vs. dividend stocks. This figure is arrived at by dividing the stock’s current market value by its EPS. For example, a stock that’s currently priced at $50 per share and has an EPS of $4 would have a P/E of 12.5.
Growth stocks usually have pretty high P/Es because current investors are lining up to buy the stock assuming that big growth is in store. There’s the risk that it won’t, of course, but a high P/E (more than 25) doesn’t necessarily indicate a company in trouble. You may still be able to get in on it and reap profits down the line.
Dividend stocks typically have low P/Es. Investors will often wait to enter into dividend stocks until their price is low enough to get in. The hope is that the company will continue to be valuable or maybe even grow a little bit more. But essentially, they’re just looking for a layer of security in their portfolio that’s at least a little predictable.
These two data points aren’t necessarily the same thing. For a growth stock, sales or revenue can be good indicators of how well things are going at the moment. If a company sells a lot of products and shows a pattern of growth, now might be a good time to get in.
Profitability is more important if you’re looking for value or dividend stocks. Since some of the company’s earnings are paid out to stockholders, the net profitability should at least be in the black. This shows the dividend stock company can afford to reward their stockholders directly — so it might be worth it to buy and hold.
The question of growth vs. dividend stocks, in the context of one’s portfolio, isn’t an exclusionary one. Portfolios optimally should hold a mix of assets — one that provides a basic foundation as a hedge against economic uncertainty, as well as opportunities for substantial growth.
The answer depends on your investment goals, and how much risk you’re willing to stomach in times of economic uncertainty. Some investors are all about the growth stock, meaning they’re more comfortable taking on that risk for a big payday.
Other investors gravitate toward dividend stocks because they’re more concerned about keeping their nest eggs safe, with a little bonus cash coming their way every quarter.
For long-term success, it’s best to have both growth and dividend stocks in your portfolio. There’s no hard and fast rule about what the ratio should be. It’s more important to focus on diversity. Your portfolio should reflect several different industries and business sectors and have a healthy, even asset allotment across all commodities.
Gorilla Trades has helped out clients find the most promising and profitable growth stocks for more than 20 years. Our metric-driven picks and innovative methods can add substantial value to your portfolio. To find out more, sign up for a free trial.