Investing in the stock market can be difficult, especially with so many different types of stock choices. One way of making stock selection a bit easier (and understandable) is by breaking stocks up into three groups: company size, sector and category.
Size is the company’s total dollar market value (market capitalization) and sector designates a specific segment of the economy (i.e. Healthcare, Financials, Information Technology, etc.). For this post, we will be focusing on category – and that’s where the terms growth and value enter the picture.
Growth vs. Value
Growth stocks represent companies that have provided earnings exceeding their industry average and are expected to continue generating above-average profit growth. Many growth stocks do not pay dividends but instead reinvest profits into programs that will further increase earnings.
You can identify a growth stock by analyzing its historical growth rate and comparing it to that company’s industry average. If it’s been on a consistent growth trend and its price per share is above the industry average, it’s a growth stock.
Value stocks are companies selling at a price below where they should be, based on financial and technical indicators. It could be that the price dropped due to a single news story or other factors that have little or nothing to do with a company’s actual operations. This type of “undervalued” stock has hidden value that investors (and company owners) believe will eventually come to light and bring the share price back to its previous levels.
You can identity a value stock by comparing its current share price to its intrinsic value and examining its history to find stable earnings and a healthy return on equity. If the current share price is below what its stellar earnings, ROE and technical indicators exhibit, it’s a value stock.
Okay… so now what?
With an optimistic belief that the above explanation of growth and value stocks is clear, you might now be asking the question: Why would I invest in growth stocks over value stocks, or vice versa?
As with just about every other question involving the stock market, the answer is not black and white. However, in the end, it all comes down to risk versus reward.
With growth stocks:
- Investors pay a higher price per share expecting to sell the shares at an even higher price as the company grows. (Increased risk, uncertain reward)
- There’s a greater chance of higher earnings during slow economic growth compared to non-growth companies (Lower risk, high potential reward)
- Share price can fall quickly based on negative news or one bad quarter of growth. (Higher risk, lower reward.)
With value stocks:
- Investors pay a lower price per share expecting that the company’s value will revert to previous levels due to its strong technical indicators. (Lower risk, uncertain reward)
- A long-term investment outlook might be required because of the potential for price fluctuations. (Medium risk, long-term reward potential)
- Prices are a “bargain” since the company has solid fundamentals and simply requires recognition by investors for the price to jump. (Medium risk, higher reward.)
That cleared things up, right?
Didn’t think so. And there’s a reason for that: the investment strategy battle between growth and value stocks has been going on for decades. Every investor has their own reasoning as to why they think growth or value stocks are a better investment and it’s usually based on the results of their own, individual portfolio. And since everyone’s portfolio is different, using another’s profit (or loss) to determine your own investment strategy is probably not the best approach to take.
So is there an answer? An end to the battle? A way to gain the potential rewards of both growth and value investments? The answer is“YES!”.
It’s called a” blended” investment and works very well when investing for the long-term. Many investors combine growth and value stocks (or funds) into their portfolio, providing them the potential for higher returns with less risk. This way, no matter what the market conditions, you should be able to consistently maintain your returns. The blended investments is the perfect way to take the facts you have about a stock or fund and build a portfolio that best suits your needs, risk-tolerance and investment objectives.
Have more questions about personal finance? Look around our FICO Forum and see how other myFICO members might be investing their money.