Finance / Fundamental Analysis / Investments · January 14, 2022

Why Are Growth Stocks Better Than Dividend Payout Stocks

Introduction

Growth stocks and dividend payout stocks are stocks that are divided based on what they do with their Profit After tax. A growth stock re-invests its money back into the business for expansion or try to diversify the other reach of market segments. A dividend payout stock on the other hand, takes the profits made from the firm and gives it out as dividends to its investors.

What stocks can be classified as growth stocks

Growth stocks are companies that are generally in the process of growing their sales, client base, or branching out into new areas.

It can also be considered as a business that is expected to increase at a pace that is much higher than the market average. These stock usually don’t pay out dividends because growth stock issuers are often businesses that seek to reinvest any profits in order to increase growth in the short term.

Reasons why growth stocks needs to be preferred over dividend payout stocks

Saving on taxes on returns made

Tax saving tactics are by far the most important reason for young investors to choose growth stocks over dividend payout stocks.

In case of growth stocks, the investor is liable to pay taxes only when he realizes its profits. Meaning the long term capital gain tax will be effective only on the year he sells those shares.

Long-term capital gains tax in India is 10% on earnings over Rs. 1 lakh, with a Rs. 1 lakh profit exemption.

On the other hand, in case of dividend stocks, in order to issue the dividends, the company has to initially pay a dividend distribution tax, and the investor will again pay tax on his personal gains. Thus, there is a scenario of double taxation. This results in lowering the valuations of the company.

Higher potential for Long term capital appreciation

Growth stocks tend to grow their intrinsic value over time, due to the accumulation of reserves and diversification of business. As a result, the stock witnesses a long term capital appreciation.

Capital appreciation can proceed in a passive and steady manner. Long term capital appreciation may or may not be recorded in financial accounts. The appreciation from the time it was first purchased becomes the profit when sold.

Participating in the bull run of the stock

If you have observed any price chart pattern of a company, one may observe that the prices of a stock does not grow in a linear fashion. Stock prices escalate in an exponential manner and it required extensive amount of research to identify the sectorial bull run.

The growth stocks, since they are at higher valuations, benefit the most from these bull runs. Hence, staying invested in a growth stock for a longer duration can fetch a better average return on your capital invested.

Growth of company’s reserves

Reserve and surplus act like a backbone for a company during crises. There can be instances in the future like COVID-19 which can disrupt the economy to a high extent. In this scenario, when the company isn’t making any revenue still needs to fund its expenses.

There can also be instances when a company incurs financial losses in a particular year. These losses may be temporary, but can create a long lasting impact on the overall performance of the company.

A management of good reserves and surplus can act like a protection fund for the company during the times of crises. A company should first focus on creating a strong reserve for itself before paying out profits and dividends. A good reserve can also increase the confidence in the management and stakeholders about the company’s well being and in turn hike up the stock price.

Reinvesting the profits back in the business

The value of the stock price is always in proportionate to the development of the business. And for a good business to flourish, the firm needs to have a strong financial backing. When a company reinvests its profits back into the business, it is a clear indication that the management behind the organization is keen in taking the business ahead.

A good supply of funds can initiate the company in experimenting different business models, spend money on research and development and hire more people into the business.

Does that make dividend stocks bad?

Of course not! There is a fine line between selecting a portfolio between growth stocks and dividend payout stocks. An investor with a higher risk appetite can allow himself to participate in growth stocks. On the other hand, an investor, who is much older in age can rely on dividend payout stocks for a lower risk and regular income.

Conclusion

One needs to understand that growth stocks come with a higher risk than dividend stock. This is due to the fact that growth-oriented businesses are in the process of establishing themselves and dominating the market. On the other hand, dividend-paying enterprises are generally developed on a huge scale and their operations are mainly automated.

Also read: How To Choose The Right Penny Stocks In India

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