Value vs. growth stocks — how to choose for investing

What is a value stock?

When you invest your money, it’s a given that you expect it to grow. Two common strategies seek to capitalize on market growth. One involves investing in value stock and the other utilizes growth stock. Value stocks are shares in a well-established company with a history of strong financial performance, that are traded at a lower share price than their performance indicates. It’s like getting a good deal on a popular item. Value stocks usually include shares from large, stable companies like financial institutions or energy companies. The risk with this type of stock is that it may never reaize the growth potential forecasted for it by analysts.

Both value and growth stocks have their advantages and disadvantages (we’ll take a closer look at growth stocks in the next section). Because everyone’s current situation and future goals are different, the information in this article, or any article for that matter, should not be taken as individual investing advice. Instead, use this information as a guide as you discuss your investment options with a financial professional, preferably a fiduciary. If you don’t have one, we can connect you with an experienced financial professional in your area.

How to identify value stocks

Identifying undervalued stocks is educated guessing. No investor can predict the future, and positive results are never guaranteed. That said, there are some calculations many use to try to find indicators of an undervalued stock. One common way is to compare the company’s stock price with its earnings. Companies that are traded at a price that’s lower than their price-to-earnings ratio (P/E ratio) are considered value stocks. The P/E ratio is calculated by dividing the stock price by the earnings per share.

P/E ratio = stock price earnings per share

This ratio is an expression of how much investors are willing to pay for each dollar of profit the company makes. For example, a stock may trade at $100 per share while its earnings per share is $5. This means investors are paying $20 for every $1 of earnings, so the P/E ratio is 20, which is $100 $5. A lower P/E ratio is usually considered a better value.

The P/E ratio, however, may give an incomplete picture. Is the ratio high because the company is growing rapidly or because the company is in decline? The P/E ratio can also be affected when a company sells assets to offset cash flow issues. That’s why investors are encouraged to use the P/E ratio along with other indicators, such as the price/earnings-to-growth ratio (PEG) and the price-to-book ratio (P/B), to better evaluate the stock price.

The PEG takes growth into account by dividing the P/E ratio by earnings growth. The P/B ratio compares the stock price to the value of the company’s assets on the balance sheet. When both methods are taken into account, a lower ratio can indicate a reasonable valuation.

How to find undervalued stocks

Calculating P/E ratios for stocks can seem like a lot of work, especially when being thorough and considering multiple factors as a financial analyst would. Some financial institutions like Fidelity and Morningstar offer free platforms to help investors examine stocks.

What is a growth stock

Growth stocks are shares in a company that may seem overpriced when compared to the company’s performance. This type of stock places greater value on the company’s potential for growth rather than on its current financial performance. Investors may be willing to pay a higher price based on the expectation that the company is in a fast-growing industry or is about to introduce a product that will become the next big thing. Growth stocks often include companies in the technology sector. The main risk factor for growth stocks is their volatility.

How to identify growth stocks

When it comes to growth stocks, the price per share can be relatively high when compared to the company’s sales or profits, so you can’t use the same methods to identify them that you use to identify value stocks. Instead of examining the current state of the company, finding growth stocks is about evaluating their future. There are various ways to gauge this potential, but it’s often less clear. Innovation is difficult to calculate. A company that has a large expandable market, strong revenue5, and earnings growth year over year, and/or a focus on reinvesting profits back into the company can be signs of a potential growth stock.

Comparing value stocks and growth stocks

There’s no way to compare value and growth stocks with one simple measure. However, growth stocks will usually have a higher P/E ratio, while value stocks have a lower ratio. Investors are willing to pay a higher price for growth based on the anticipation of higher future returns, and view value stock as an opportunity to pay less for a higher-value stock that is expected to continue performing well. Another distinguishing characteristic is that value stocks often pay dividends. Growth stocks, on the other hand, usually roll profits back into their operations to fuel further growth.

Advantages and disadvantages of value vs. growth stock investing

It’s also worth noting that the same stock can be classified as a value stock at one time and as a growth stock at another. For example, when a new technology is in its infancy, the company’s stock may be considered growth stock. Once that technology is widely adopted and the company performs well over time, its stock may be viewed as value stock.

Is value or growth investing worth it?

Value and growth investing are two distinct yet significant approaches to investing. They provide a structured way to evaluate your stock choices. This can be helpful in creating a diversified portfolio. The advantage of value investing is that it may tend to be less volatile than growth investing. The advantage of growth stock is that it positions you to take advantage of a company’s future growth. Value and growth investing carry the disadvantage of being subject to market volatility.

Value vs. growth: Which should I choose?

Whether you’ll be served best by value or growth stocks is generally determined by factors like your timeline or stage in life, your tolerance for risk, and your goals.

When value investing is the best choice

Value investing is often seen as a favorable approach by investors with a low risk tolerance because of the perceived stability of the companies. This approach may be especially suitable for those closer to retirement who may want to rely on dividends to supplement their retirement income.

Although value investing as a philosophy is often considered a lower risk option, it’s important to learn about the companies behind the stock and their financials to get an understanding of their trading price. Stocks can be undervalued for several reasons, many of which may not be good indicators of future success. Sometimes a product recall or a PR crisis can affect share prices and it’s important to evaluate whether the occurrence is something the company can overcome, allowing its share prices to rise again as time passes.

When growth investing is the best choice

Growth investing is usually better suited to individuals with higher risk tolerance who are further from retirement. The higher potential for rapid growth is often accompanied by higher risk and volatility. Being further from retirement allows time for your portfolio to recover from market downturns.

Value vs. blend vs. growth

Value and growth stocks both have their place in sound investment strategies. Diversifying is essential to managing risk and maintaining a healthy portfolio. Mutual funds often include both value and growth stocks in varying proportions to meet different investing styles, degrees of risk tolerance, and goals. Consulting a professional financial advisor can help you find the right balance.

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