How Growth and Value Stocks Differ

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How would you define a growth or value stock? You hear these terms associated with value and growth investing, but you might not fully understand what they mean. There are no hard and fast definitions of growth and value stocks, but many investors agree on some general criteria that define these two types of investments.

Learn the differences between them to help you determine which type you prefer to have in your portfolio, or how you'd use them to diversify it.

Identifying a Growth Stock

Growth stocks have some common characteristics, although individual investors may tweak the numbers for their purposes. There are several indicators you might see that signal a growth stock:

  • Strong growth
  • Return on equity
  • Earnings per share
  • Earnings before taxes
  • Projected stock prices

A stock should have a strong growth rate projected forward and historically. You'd want to see past growth rates of 10% or higher in small companies for the past five years and rates of 5%–7% in larger companies.

The idea behind growth investing is to focus on a stock that is growing with potential for continued growth. Value investing seeks stocks that the market has underpriced, which have the potential for a value increase if the market makes a price correction.

It's preferable to see these same rates or more in a business' forecasted five-year growth rate. Generally, large companies don't grow as fast as small companies, so accommodations should be made based on their size, age, and performance.

Return on Equity (ROE) is a measure of how efficiently a company uses the money investors give it. It helps to compare stocks across the industry the company is in. This gives you an idea of how the company's ROE stacks up against its competitors.

Earnings per share (EPS) is the amount of earnings one share brings in for its investors. This measures the ability of a company to generate profits for common shareholders. If EPS is growing, but the number of outstanding shares holds steady, it indicates there is more capital being generated with the same number of shares.

Earnings before taxes (EBT), also called the pre-tax margin ratio, is important because it demonstrates a company's operational efficiency. Is the company translating sales into earnings? Is management controlling costs? EBT should continually exceed the past five-year average and the industry average to establish growth.

Financial analysts calculate projected stock prices. Generally, a stock's page on any of the public exchange's websites will give you current and predicted prices. The analysts make stock price projections based on the company's business model, market position, economic and consumer trends and expected investor sentiments.

It's important to note that a stock may not meet all of the above criteria but could still be a growth stock. For example, it may not have the operating history for a five-year look but could still occupy a significant place in a rapidly growing new industry.

Identifying a Value Stock

Value stocks are not necessarily 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.

Value stock's prices are low because the market has undervalued them for various reasons, and investors hope to get in before the market corrects the price. Here are some characteristics to look for in a value stock:

If the price-to-earnings ratio is in the bottom 10% of all company's stock, it is undervalued and can be considered a value stock because the price is likely to rise in the future.

If a stock has hit 52-week lows and has a high debt-to-equity ratio compared to the rest of the industry, it might be in the beginning stages of growth. However, use this ratio as a gauge carefully because it might show the company has an unsustainable debt level.

The current ratio is a measure of how a company can cover its short-term debts with current assets. Current assets are assets that a company expects to sell or can liquidate within the next year, and short-term obligations are due within the next year.

Businesses can sell or liquidate current assets to cover their short-term debts—the current ratio tells investors how easily they can do this. A ratio of less than one signifies the business may not be able to pay its obligations.

Tangible book value is the value of a share reported on a business' last balance sheet. If a stock's share price is below tangible book value, the stock might be undervalued and is likely to receive a correction from the market.

What It Means For Investors

Historically, there have been periods such as the late 1990s when growth stocks have done well—and other periods when value stocks outperformed growth stocks. Investors should hold both to diversify their portfolios and hedge risk.

Both growth and value stocks come with different risks. Growth stocks might be volatile and not grow, and value stocks might not gain momentum and suffer a collapse. Choosing the right one is not solely dependent upon the ratios or past financial performance.

When comparing growth or value stocks, assess how long the company has been operating, market conditions and conditions of the industry they operate in. The level of risk you find acceptable is essential as well—as the market, economy, and investor sentiments fluctuate, the risks change for both investments. Diversification helps investors stay afloat in the wild sea of investing.

A diversified portfolio has both value and growth stocks within it. If you find you have only one kind in yours, consider the main benefit of diversification—mitigating risk. If you are starting, plan your portfolio to have a good mix of value and growth stocks.