How Growth and Value Stocks Differ
How would you define a growth stock or a value stock? You hear these terms associated with value and growth investing, but maybe you're not clear on exactly what they mean. Although there are no hard and fast definitions of growth and value stocks, most investors agree on some general criteria that define these two terms.
When it comes to labeling individual stocks as either value or growth, there can be some disagreement for those companies near the edge of either definition. Growth and value aren't the only two methods of investing, but they are a way for investors to make a cut at stocks for investing purposes.
Historically, there have been periods such as the late 1990s when growth stocks have done well and other periods when value stocks outperformed. Your best bet is to hold both for true diversification. The idea of growth investing is to focus on a stock that is growing with potential for continued growth while value investing seeks stocks that the market has underpriced and have the potential for an increase when the market corrects the price.
Growth stocks have some common characteristics, although individual investors may tweak the numbers for their own purposes. Here are some of the indicators:
- Strong growth rate, both historic and projected forward. Historically, you want to see smaller companies with a 10%+ growth rate for the past five years and larger companies with 5% - 7%. You might want these same rates and more for projected five-year growth rates. Big companies will not grow as fast (normally) as small companies, so you need to make some accommodation.
- Strong Return on Equity. How does the company's return on equity (ROE) compare with the industry and its five-year average?
- What about earnings per share (EPS) ? Especially look at pre-tax profit margins. Is the company translating sales into earnings? Is management controlling costs? Pre-tax margins should exceed the past five-year average and the industry average.
- What is the projected stock price? Can this stock double in price in five years? Analysts make these projections based on the business model and market position of the company.
If the stock meets or roughly meets these criteria, you are probably looking at a growth stock. However, you need to use some judgment and common sense. A stock may not meet all of the criteria above, but could still be a growth stock. For example, it may not have the operating history for a five-year look, but occupy a significant place in a rapidly growing new industry.
Value stocks are not cheap stocks, although one of the places you can look for candidates is on the list of stocks that have hit 52-week lows. Investors like to think of value stocks as bargains. The market has undervalued the stock for a variety of reasons, and the investor hopes to get in before the market corrects the price. Here are some characteristics of a value stock
- The price-earnings ratio (P/E) should be in the bottom 10% of all companies.
- A price to earnings growth ratio (PEG) should be less than 1, which indicates the company is undervalued.
- There should be at least as much equity as debt.
- Current assets at twice current liabilities.
- Share price at tangible book value or less.
Some investors use more criteria, but these will get you started in identifying value stocks.
A truly diversified portfolio has both value and growth stocks. If you find only one kind in your holdings, consider the benefits of diversification. If you are just starting out, plan your investments with a good mix of value and growth stocks.