There are multiple stock strategies investors can utilize when deciding how to diversify their portfolio and select their investments. A combination of growth and value strategies is typical to accomplish diversification, but it is important to understand varying strategies in order to make a holistic decision that is right for you and your portfolio. In this blog, we will cover what growth and value investing are, how to analyze these investment strategies, and which method may be a better approach depending on portfolio needs.
What is Growth Investing?
Growth investors primarily focus on companies that have the potential to outperform the overall market and appear to have significant growth potential. The value of these companies is anticipated to increase at an above-average rate compared to their peers, potentially resulting in larger returns for investors.
Investing in growth stocks can be very appealing to investors due to the potential for a higher return. However, growth investing is high-risk. There is no guarantee that expected growth will be reached and there is always the possibility of total loss of capital. As there are no specific criteria for categorizing growth stocks, the classification of these investment types can be subjective.
The key characteristics of growth stocks include:
- The stock is typically priced higher than the broader market. Investors may be willing to pay these higher prices in exchange for the possibility of higher returns as the company grows.
- The company often has high earnings growth records. Growth companies may have the potential to maintain high earnings in the face of economic difficulties.
- The stock can be more volatile than the broader market. Growth stocks have the possibility of falling sharply in response to negative news about the company.
- It’s common for these stocks to not have a history of paying dividends and are usually not currently paying dividends; these funds are commonly reinvested to fuel growth instead.
What is Value Investing?
On the other hand, value investing focuses on companies that appear to be undervalued compared to other competitors in the market. Intrinsic value is a measure of what an asset is worth. The difference between market value and estimated intrinsic value may become a source of potential gains. Typically, the investor believes that the stock price is less than the intrinsic value the company holds, which may represent a discount, meaning their potential return has the possibility of being larger than expected. Warren Buffet is considered to be one of the most famous value investors, resulting in a net worth of over $115B as of February 28, 2022.
The key characteristics of value stocks include:
- The stock usually is priced lower than the broader market. Investors hope these stocks will increase in value to match estimated intrinsic value.
- A common belief among value investors is that value stocks can be the result of market over-reactions to company problems or negative press.
- While still risky, value stocks carry potentially less risk than the broader market due to the undervalued nature of the stock
How can investors determine whether a stock is a growth or value stock?
How to Analyze Growth and Value Stocks
There is no definite way of characterizing a stock as either growth or value. However, there are 5 key metrics and factors for each type that are commonly considered to classify these stocks.
The 5 common key metrics of growth stock are strong historical earnings growth, strong future earnings growth, strong profit margins, strong return on equity, and strong stock performance.
- Strong historical growth – Investors want to see a strong track record of growth over an extended period of time.
- Strong future growth – Investors review earnings announcements, or official public statements of a company’s profitability over a specific period of time, to determine which companies have the possibility of out-performing other companies in the industry.
- Strong profit margins – The pretax profit margin, or generally sales minus expenses, is another factor considered to determine the balance of costs and revenues. Investors want to see increasing profit margins.
- Strong return on equity (ROE) – This measure can provide insight as to how well the company is performing by comparing revenue to equity. A positive ROE generally implies the business is doing well at generating returns from shareholders’ investments.
- Strong stock performance – As a general rule of thumb, investors hope growth stock prices will increase faster than the overall market.
When analyzing value stocks, the 5 key metrics include price-to-earnings ratio, price-to-book ratio, debt to equity ratio, free cash flow, and price/earnings-to-growth ratio.
- Price-to-earnings ratio (P/E Ratio) – This ratio helps investors determine the market value of the stock compared to the company’s earnings and can provide a measuring stick as to if the stock is over- or under-valued.
- Price-to-book ratio (P/B Ratio) – The price-to-book ratio compares the company’s net or book value to its market capitalization or value. Market value is the price investors are willing to pay for the stock, and the book value is derived from the company’s own accounting records.
- Debt to equity ratio (D/E Ratio) – The debt to equity ratio compares the proportion of debt and equity utilized by the company. A high debt to equity ratio means the company receives more of its financing from debt than equity. However, the ideal value of this ratio varies from industry to industry and is one of the more subjective considerations.
- Free cash flow (FCF) – Free cash flow is considered to be the cash left over after a company has paid for its operating expenses and capital expenditures. This can provide insight to how efficiently a company generates and uses cash.
- Price/earnings-to-growth ratio (PEG Ratio) – A modified version of the P/E Ratio, the PEG ratio also considers earnings growth. Measuring the P/E Ratio against earnings growth can provide a more conclusive picture of whether or not the stock’s value is over- or under-valued.
Putting it All Together
A combination of growth and value investing is a common approach many investors take to diversify their portfolio and potentially maximize returns. While there are metrics that can be evaluated to determine if a stock is a growth or value stock, no single stock metric can provide a holistic view and understanding of the distinction. Relying on personal judgement and various calculations and ratios can provide a clearer picture of the type of stock, but these assumptions are subject to errors, nuances, and rapidly changing market conditions. It is important to thoroughly vet investment opportunities, but evaluating growth and value stocks is a good place to start.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.