Stocks are classified under one of two categories: growth or value. While that is the case, many stocks demonstrate having both worlds. In an ideal investment portfolio, you should see a mix of value and growth stocks.
Still, it’s important to understand the differences between growth and value investing and why investors would choose growth over value and vice versa.
The Differences Between Growth and Value Stocks
Growth Stocks
A growth stock is any company share that shows growth rates that surpasses the market average. That characteristic is usually because the firm offers a unique product or service or it is creating a product that may lead to a major change in the tech sector in the future.
The prices of growth stocks can be more volatile than other types of stocks. That is why investors hold them intending to make money from quick price appreciation instead of dividends.
Here are the key characteristics of growth stocks:
Higher priced than the broader market. Investors typically bet on growth stocks, expecting to sell them at much higher prices as the companies grow.
High earnings growth. A slow economy can weigh some companies’ earnings. But with growth companies, they can potentially have increased earnings, regardless of the economy’s current state.
More volatile than the market at large. A growth stock’s soaring price can sharply decline when there is negative news about the company, especially when its earnings cannot meet expectations.
Value Stocks
On the other hand, prices of value stocks can trade steadily, regardless of the market condition. However, the prices do take quite some time to move up.
Still, the significant advantage they offer is letting investors buy shares when they are undervalued or when the market sees their shares below their intrinsic value.
Then again, some investors choose growth stocks because of the opportunity of yielding more revenue than expected and earnings growth potential.
The key characteristics of value stocks are as follows:
Lower priced than the broader market. Value investing is based on the concept that a stock will recover in time if and when investors recognize its true value.
Priced below similar stocks in the market. Value stocks are undervalued that have the potential to surge and deliver significant returns in the future.
Riskier than growth stocks. The market is skeptical towards value stocks. To make a value stock profitable, the market will need to change its view of the company, which is riskier than a growth firm expanding.
Further Understanding Growth and Value Stocks
Growth companies underscore the swift and intense run from promising startups to established businesses.
Their main goal is to increase sales, revenue, and cash flow – often at the price of profitability – so their perceived value can climb rapidly. Such appreciation can result in a gain in their stock prices.
Growth stocks can seem expensive, trading at high price-to-earnings (P/E) or price-to-book (P/B) ratios. Moreover, their valuations should be determined against the commonly quick revenue and earnings growth as compared with other firms in their industries.
Value stocks, meanwhile, are significantly cheaper than growth stocks when compared with their earnings and long-term growth potential. These publicly-traded companies usually bring in small, steady gains in revenue and profits.
In fact, the business can even be in a slump. A firm can still be a value stock if its stock price is considerably down to offer a very low estimate of its future profit potential.
Choosing Between Growth and Value Stocks
Whether you’re investing in growth or value stocks, you have a chance for profitability, provided you invest wisely.
Choosing which is best will depend on your financial goals and risk tolerance. That said, your selection doesn’t need to be wholly focused on one. Berkshire Hathaway Inc. Chairman and Chief Executive Warren Buffett has stated that growth and value have some intrinsic connection.
Those two, according to Buffett, are joined at the hip. Growth is always a factor in calculating value, providing a variable whose significance can range from small to big.
Growth and Value Indexes Explained
Market indexes reflect the performances of certain stock groups, helping investors understand how different economic sectors and the stock market perform. Some of the well-known indexes follow both growth and value stocks.
For example, the S&P 500 Growth Index sources its growth stocks from the S&P 500, picking businesses with the best three-year revenue and earnings per share (EPS) growth. Stocks with the strongest upsurges in their prices are also included.
The S&P 500 Value Index tracks stocks under certain growth stock criteria. The index measures value stocks with book value, P/E, and sales to price.
The GARP Strategy Explained
Growth at a reasonable price, also known as GARP, is an alternative investment strategy that is a mix of both growth and value investing.
The approach was popularized by investment icon Peter Lynch. GARP focuses on growth companies while monitoring the conventional measures of value.
Such a blended strategy finds growth stocks with prices that align with their intrinsic value. The biggest challenge you have to face with growth investing is properly grasping the firm’s growth outlook.
Predicting future growth trends can be challenging for startups or young businesses in rapidly changing industries. While it’s possible to come up with a practical forecast, it can still be tricky to compute how much they should pay rationally to achieve that growth.
To find out if the company is reasonably priced, considering its growth outlook, GARP investors rely on the price/earnings-to-growth (PEG) ratio, which is calculated by dividing the firm’s P/E ratio by its estimated growth rate.
If you get one or less, that suggests the stock is sensibly priced, while getting higher than one may mean the stock is expensive and would not work with a GARP strategy.
Growth or Value Investing?
Growth and value investing pretty much perform on the same level in terms of long-term performance.
While growth stocks tend to perform slightly better than value stocks during an optimistic economy, value stocks are typically stronger when the economy is stumbling.
Extremes are often not good. Therefore, investing in both growth and value companies can be more ideal for your portfolio than only choosing one of them to hold.
It also depends on certain factors like your progress in the investor life cycle, the time you have until retirement, and the economy’s current condition. By looking at and analyzing those three, go for the investment strategy that seems to fit your goals best.
