From time to time, we like to clarify the many different terms within the jargon-filled world of finance. This has formed a series of entries into the Legend Glossary.
Distinguishing Between Growth & Value
The main difference lies not in how they are bought and sold, nor in the ownership percentage they have in a company, but rather the way growth and value stocks are perceived by the market and, by extension, the investor.
Both forms can be viewed as styles of investing in stocks. Neither style is guaranteed to turn into an appreciation in stock market value and both carry risk. The return and principal value of stocks fluctuate as market conditions themselves change. Shares, when sold, may be worth more or less than their original cost and, accordingly, those with higher potential rates of return tend to equate to a more risky investment.
Often associated with high-quality companies whose earnings are expected to continue growing at an above-average market rate, growth stocks generally have high price-to-earnings (P/E) ratios and high price-to-book (P/B) ratios.
The P/E ratio is the market value per share, divided by the current year’s earnings per share. For example, if the stock is currently trading at $52 per share and its earnings over the last 12 months have been $2 per share, then its P/E ratio is 26. The P/B ratio is the share price divided by the book value per share. The open market often places a high value on growth stocks, and so their investors may see these stocks as having great worth and pay more to own shares.
Investors who purchase growth stocks receive returns from future capital appreciation (the difference between the amount paid for a stock and its current value), rather than dividends. Although dividends are sometimes paid to shareholders of growth stocks, traditionally it has been more common for growth companies to reinvest retained earnings in capital projects. Recently though, lower tax rates on corporate dividends have led to even growth companies offering a dividend option.
At times, growth stocks may be seen as expensive and overvalued, which is why some investors may prefer value stocks, which are considered undervalued by the market.
Generally traded at a lower price relative to their fundamentals (including dividends, earnings, and sales), value stocks tend to have good fundamentals but may have fallen out of market favor. For this reason, they are often priced at 'bargain' levels, compared to their competitors. They may have prices that are below the stocks’ historic levels or may be associated with new companies that aren’t recognized by investors. These companies may have been affected by some concern that raises questions as to their long-term prospects.
Value stocks generally have low current P/E and P/B ratios. Investors buy these stocks in the hope that they will increase in value when the broader market recognizes their full potential, which should result in rising share prices. Thus, they hope that if they buy these stocks at bargain prices and they eventually increase in value, they will make more money than if they had invested in higher-priced stocks with only a modest rise.
Understand Which Is Best For Your Investment
Growth and value investments tend to run in cycles. Understanding the differences between them may help you decide which may be appropriate to help you pursue your specific goals.
Regardless of the type of investor you are, there may be a place for both growth and value stocks in your portfolio. This strategy may help you manage risk and potentially enhance your returns over time.
Always clarify any questions with your financial adviser before making decisions on these and other additions to your portfolio, so that your own personal investment preferences and situation can be factored in.