Oct 16, 2023
Value vs. Growth Stocks
When you’re investing in stocks, it’s all about balancing your tolerance for risk and the potential rewards of the market. Whether you lean more toward rapid results or promising prospects, the types of stocks you choose are important in enacting your investing strategy. Experts often divide stocks into one of two classifications: value stocks and growth stocks.
Stocks classified as value stocks typically trade at a discount with the expectation that the value will increase over time, while those classified as growth stocks tend to sell at higher prices because they’re already seeing rapid growth. And because these classifications are determined by current market conditions, they may change. Keep in mind that value investing and growth investing strategies are not mutually exclusive. You can benefit from including both kinds of stocks in your diversified portfolio.
What are value stocks?
Value stocks are shares trading at a bargain price, though that doesn’t necessarily mean cheap. In general, the stock price is a bargain when the shares are considered to be worth more than you’re paying for them. This may be the case when a company that has historically shown strong, stable performance experiences a dip in share value due to overall market conditions, volatility in its industry, or a temporary setback in the company’s outlook. So think of value investing as simply buying shares at an undervalued price. Value stocks tend to be less risky and often pay dividends. They’re usually issued by larger, more established companies that are temporarily undervalued, which contributes to their relatively stable reputation.
What are growth stocks?
Growth stocks are precisely what they sound like: stocks that are rapidly growing in value; they’re often expected to outperform the market, at least in the short term. You’ll often find them issued by companies that are getting a lot of media buzz and usually posting impressive earnings. Investor enthusiasm for these companies often translates into increased demand for their stock and investors’ willingness to pay more, which means higher share prices. As share prices rise, sometimes dramatically, the investors who own those stocks see higher returns. However, these stocks are more prone to volatility, so their prices can plunge or skyrocket rapidly, which leads to more risk for investors.
Key differences: value vs. growth stocks
Growth stocks typically gain market momentum because the company is doing something new and exciting that drives up demand for shares, or has some sort of market advantage. Value stocks are often shares of a company whose stock price may be lower compared to its historical value, peers in the same industry, or the company’s potential for earnings growth. The differences between value stocks and growth stocks are further demonstrated by five key characteristics: price, P/E ratio, company earnings, risk, and dividends.
|Lower than the broader market (undervalued)
|Higher than the broader market (overvalued)
|May not appreciate as much as expected
|Generally high earnings growth
|Relatively high volatility
|Often pay dividends
|Rarely pay dividends
Stock prices are determined by how much buyers are willing to pay and the amount sellers are willing to accept. In general, growth stocks are perceived as overvalued, trading at higher prices than would be expected based on their price-to-earnings ratio. In contrast, investors see value stocks as undervalued by the market, believing that their true worth is higher than the current price. Investors expect the price of value stocks to increase, but not as aggressively as growth stocks.
The price-to-earnings ratio, or P/E ratio, is the ratio between a company’s stock price and its earnings per share. Investors use this figure to determine if what they pay for a stock is a good deal compared to the company’s expected performance. Investors generally prefer a lower P/E ratio, because they’ll spend less money for each dollar a company earns. However, investors may see a high P/E ratio as a signal that a stock’s value will continue to increase. Value stocks tend to have lower P/E ratios than above-average-performing growth stocks.
As with the P/E ratio, the company’s earnings prospects tend to be lower for value stocks and higher for growth stocks. Growth companies often show potential for earnings growth even when overall economic conditions aren’t ideal. In the case of value stocks, the company’s earnings may not increase as much or as quickly, but they’re expected to rise over time.
Growth stocks tend to be more volatile, making their performance less predictable and therefore more risky. The very conditions that drive their overvaluation can change rapidly, leading to rapid peaks and valleys in stock price. In comparison, relatively stable value stocks are less volatile. The lower share price of these companies is seen as a temporary dip that will be corrected in time, so value stocks are generally considered a more stable investment.
Dividends are one way investors can make money on their investments. These periodic payments provide a return regardless of fluctuations in a stock’s price. Not all companies pay dividends, but most value stocks do. Growth companies, however, tend not to pay dividends because they’re more likely to reinvest earnings back into the company instead of distributing them to shareholders.
Value investing vs. growth investing: which is right for you?
Both value investing and growth investing strategies come with their fair share of benefits and risks. While one strategy may be more appealing to you based on your time horizon and risk profile, you’re not required to limit yourself to just one approach. Even well-known value investor Warren Buffett includes growth investing in his strategy. It’s all about evaluating the risk of value vs. growth stocks to find a balance that works for you.
Your time horizon, or how long you plan to hold onto an investment, can help you determine whether a growth or value investing strategy is the best fit. More stable value investments tend to be the right speed for investors with shorter time horizons that can’t accommodate the risk of sudden drops in their investments’ value. Undervalued companies may not regain their value overnight, but their share price can start rising, sometimes quickly, once they turn things around. Growth investing, on the other hand, may appeal to those with a longer time horizon because there’s time to ride out the potential ups and downs of a growth stock’s price. And even if a growth company’s share price continues to rise, it may take quite a while for it to realize its full potential, with possible stumbling blocks along the way.
Factors like your age, current income, and savings goals can influence how you feel about risk. All investing comes with a certain amount of risk, but understanding how much you’re willing to tolerate helps you determine which investment strategy is right for you. Investors with an aggressive risk profile may feel more comfortable with the volatility of growth stocks, while conservative or moderate risk-takers may prefer the relative stability of value stocks.
It’s risky to put all your eggs in one basket, and the same is true for your investment portfolio. That’s where diversification comes in. Spreading the overall holdings in your portfolio across different asset classes can reduce your overall risk. Choosing a balance of growth and value stocks can play an important role in a diversified portfolio. By combining both value investing and growth investing, you could balance the risks of volatile stocks with more stable investments.
How to identify value vs. growth stocks
Whether a company’s stock fits into the growth or the value category depends on the current market. For example, growth and value stock outlooks can change quickly if an undervalued company releases an innovative product, or if a rising star’s latest venture flops. When you want up-to-the-minute information to help you identify value vs. growth stocks and find potentially high-yield investments, bear in mind these three tips:
- Consult the Russell 1000 indexes, which were designed to provide investors with accurate benchmarks for measuring the growth and value of equity market segments.
- Look for undervalued stocks that have potential to regain their value and continue to increase.
- When looking at a company whose stock price seems like a bargain, evaluate its market cap to get a sense of its size, stability, and growth potential.
Value vs. growth investing: find your balance
So what’s right for your portfolio when it comes to value vs. growth stocks? Maybe both. To keep your holdings diversified, you may want to invest in a mix of stocks, both classic solid bets that are momentarily undervalued and new, dynamic companies with high potential. Balancing growth stocks with value stocks in your portfolio may help maximize your potential returns while lowering the overall risk. It’s all about what makes the most sense for you and your financial goals.
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