What is a growth or value stock? You may hear these terms without fully understanding what they mean. There are no hard and fast definitions of growth and value stocks. But many experts agree on some general criteria that define these two types of investments.
Learning the differences between them can help you decide which type you prefer to have in your portfolio or how you'd use them to diversify it.
How to Identify a Growth Stock
Growth stocks have some common characteristics. But individual investors may tweak the numbers for their purposes. There are a few 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 in the future, but keep its past in mind as well. You'd want to see past growth rates of 10% or higher in small companies for the past five years; look for rates of 5%–7% in larger firms.
It's preferable to see these same rates or more in a business' forecasted five-year growth rate. Large companies often don't grow as fast as smaller ones, so be sure to keep their size, age, and performance in mind.
Return on equity (ROE) is a measure of how well a company uses the money from its investors. It helps to compare stocks across the industry the company is in. This gives you an idea of how the ROE stacks up against its competitors.
Earnings per share (EPS) is the earnings that one share of stock 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 shows there is more capital being generated with the same number of shares.
Earnings before taxes (EBT) is also called the pre-tax margin ratio. It's important because it shows 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. In most cases, a stock's page on any of the public exchange's websites will give you current and predicted prices. Stock price projections are based on the firm'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 instance, it may not have the history for a five-year look; however, it could still be a big player in a growing new industry.
How to Identify a Value Stock
Value stocks are not always cheap stocks. But one of the places you can look for value stocks 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. The idea is to get in before the market corrects the price. Here are some things to look for in a value stock:
- The price-to-earnings ratio (P/E)
- The price-to-earnings growth ratio (PEG)
- The debt-to-equity ratio
- The current ratio
- The share price vs. the tangible book value
If the price-to-earnings ratio is in the bottom 10% of all company's stock, it is undervalued. This means it is 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. Use this ratio carefully because it might show the firm has an unsustainable debt level.
The current ratio is a measure of how a firm can cover its short-term debts with current assets. Current assets are assets that can be sold or liquidated within the next year. 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 shows how easily this can be done. A ratio of less than one means the business may not be able to pay its debts.
Tangible book value is the value of a share reported on the last balance sheet. If a stock's share price is below the book value, the stock might be undervalued. It is likely to receive a correction from the market.
What It Means For You
There have been times, like in the late 1990s, when growth stocks have done well. There are other periods when value stocks outperformed growth stocks. You should hold both in order to diversify your portfolio and hedge risk.
Both growth and value stocks come with their own risks. Growth stocks might be volatile and not grow. Value stocks might not gain momentum and suffer a collapse. Choosing the right one is about more than just ratios or past performance.
When comparing growth or value stocks, think about a few different things: how long the company has been operating, and the conditions of the market and industry. Also, keep the level of risk you're OK with in mind as well. As the market, economy, and investor sentiments change, the risks change as well. Diversification helps you to 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 just getting started, plan your portfolio to have a good mix of value and growth stocks.