Growth Stocks vs Value Stocks – what exactly is the difference between these two types of stocks? And why do these differences matter? Let’s find out.
First, though, let’s think about why knowing the difference between growth stocks vs value stocks is actually useful.
How do you know when to buy or sell? It’s a question that plagues any investor because stocks go up and down all the time.
By the way, if you’re reading this on a day that the stock market is down, you may want to learn why the market is down.
Now, it’s easy to buy or sell stocks.
But making a profit on securities is the basis for an entire industry. One that is active every hour of the day around the world.
One of the best ways to understand when a stock is a good buy is to understand whether it falls into the category of growth stocks or value stocks.
At the end of the day, both categories give investors a way to estimate how the market is valuing a particular company.
The methods used to identify a stock as either growth stocks vs value stocks are very distinctive and the goals are quite a bit different.
This article will help you understand growth stocks vs value stocks by comparing the differences that matter.
What Is A Growth Stock?
In a nutshell, a growth stock is simply a stock that maintains (or is expected to maintain) a high growth rate.
They are found in not only the large-cap (large market capitalization) category but also in mid-cap and small-cap stocks.
One would intuitively expect smaller firms to tend to have higher growth rates, and this is a reasonable intuition.
A funded tech startup is probably growing at a faster rate than a Fortune 100 company. Exceptions do exist of course, naturally.
But generally speaking, smaller firms will tend to have higher growth rates vs. larger ones.
How To Identify A Growth Stock
For those investors interested in growth investing, it is important to identify companies that are returning value to shareholders by reinvesting earnings into new growth opportunities rather than paying back shareholders in the form of dividends.
This is not, however, the only metric to use for growth investing.
Any strong investment requires a deep dive into the management of a company as well.
This is assuming you’re taking a fundamentals-based approach to investing; and that you’re a fundamental investor.
RELATED: Types of Investors in Stock Market
Identifying strong corporate management is a bit difficult. But there are ways investors can get a rough idea that the company is run well.
Good indicators might include corporate managers who have:
- been in their positions for a while,
- proven success at previous companies, and
- clear strategic goals.
Growth companies also tend to have an innovative way of doing business.
They might have an innovative new product that gives them an edge over the competition.
Think of companies like Amazon and Apple, both of which continued to break valuation records even during the Covid-19 pandemic or times of crises.
Growth Stocks and Declines in Stock Prices
All of these points might give a company the visual of being overvalued since metrics like P/E ratio, earnings per share (EPS), and even stock price will likely be much higher than that of their competition.
However, growth stocks will theoretically continue to grow until the market feels that a plateau has been reached.
A great example of the market’s reaction to plateau or declining growth can be seen in Meta’s (formerly Facebook) stock price.
Notice that the price of FB fell from approximately $325 down to about $237 overnight (a decline of approximately 27%).
This significant decline in February 2022 was driven almost entirely by the market’s reaction to Facebook’s decline in active users.
The drop in active users means markets now expect Facebook’s (now Meta) revenues to decline, which in turn starts its own domino effect including:
What Is a Value Stock?
Value stocks, in contrast to growth stocks, represent those companies that are undervalued as compared to their peer companies.
Importantly, the distinction between growth stocks vs value stocks isn’t a simple “either-or” relationship.
A value stock can also be a growth stock. This might be either in parallel, or sequentially (e.g., it was a growth stock in the past, but then became a value stock).
Value stocks can also be found in either large-cap, mid-cap, and small-cap stock categories.
How To Identify A Value Stock
Value stocks are generally those that are available to “buy at a bargain”.
They represent stocks that the market is pricing far lower compared to similar companies in the same industry.
Put another way, value stocks are trading below what they are really worth. The idea’s that the market may not yet be pricing that value into the stock price yet.
This notion would be contrary to the strong form of the efficient market hypothesis, but not necessarily contrary with the other forms of the EMH.
Popular metrics to use in your search for value stocks include:
- P/E ratio,
- Market to Book Ratio,
- Cash flow ratios
Some will try to put hard numbers on what signifies a P/E ratio or MTB (Market to Book) ratio that indicates a company is a value stock. But oftentimes, these hard numbers are extremely arbitrary.
Some investors simply follow companies that are well known. And they might look for opportunities to enter the market when they show indications of having become value stocks.
This might have worked in the past, but comparing one stock to the broad market is a bit non-specific.
Value investing faces the same paradox that any/every other investing strategy faces.
If an investing strategy becomes mainstream – i.e., if many people know/apply it – then it will cease to be profitable!
Indeed, this is why we don’t tend to see arbitrage opportunities
Comparing Target and Comparable Firms
Another way to locate value stocks is to compare the financial indicators of your target company with those of its competitors.
For example, if you wanted to buy a value stock in the chip manufacturing industry, you might compare Intel, AMD, and Nvidia.
Since these companies all have different valuations and stock prices, the most accurate way to compare companies in the same sector is by using the ratios like price to earnings, price to book, price to sales, etc.
The biggest challenge in practice is finding the right comparable firm.
We go over this challenge – and intricately detail how to solve it – in our stock valuation course.
So if you’re interested in genuinely identifying value stocks by valuing stocks from scratch, do check out the course and enroll in it.
These metrics can seem complicated, but if you understand them then you’ll find it easier to compile your own database and identify value stocks.
Using data-driven investing strategies can be a benefit here too. But you’ll need to learn where to start before creating your own strategy.
Can A Value Stock Also Be a Growth Stock?
This was alluded to previously, but value stocks can also be growth stocks.
Being categorised as both a growth stock and a value stock happens rarely, but companies swing from value stock to growth stock categories all the time.
It really depends on the perspective of each investor and what metrics are being used to locate stocks for their portfolio.
Are Value Stocks Better For Investors Than Growth Stocks?
Neither category is necessarily better than the other.
While Warren Buffett has made a name for himself as one of the best value investors of all time, growth stocks are a popular focus for most average investors.
This may be partially because of the fact that growth companies have tended to be those that many people are familiar with.
Regardless of Buffett’s success, investors would be best served by choosing to focus on either growth stocks or value stocks and fine-tuning the tools used to locate companies that fit their criteria.
Growth stocks don’t typically pay dividends because earnings are reinvested in the company.
Value stocks may offer dividends as well as capital growth, though the stock price will generally not rise as much as that of a growth stock.
That’s because firms that pay out dividends have lesser money available to reinvest into the business for growth.
This in turn means lower future cash flows for the business, and a lower present value of future cash flows as a result.
What’s Next – Growth Stocks vs Value Stocks
Growth stocks are stocks that maintain or are expected to maintain high growth rates.
These stocks tend to reinvest earnings in new projects and return value through higher stock prices.
Value stocks are those which are priced below what the company may actually be worth, and which provide a discount entry point for investors.
Put differently, these stocks can be “bought at a bargain”.
Finding out which one is best for you is perhaps something that becomes clearer with time. But it’s important to choose one and learn the strategies that will help find opportunities.
Only through consistent practice and learning new tools can investors find success in volatile markets.