The dynamic world of investing offers two main strategies most tend to focus on: growth and value. Both strategies offer pathways to potentially reap rewards from the stock market, but most importantly, they have different characteristics and potential risks and gains they entail.
Here we have curated some important facts about both offerings, presenting simplified pros and cons to aid your decision based on financial goals and risk tolerance. Whether you lean towards growth or value, understanding this investment choice is crucial.
Growth
Growth stocks are shares of companies that are expected to increase in size much faster than either the average growth of a company within the wider market or within its specific sector due to their future potential. Focused on high earnings growth compared to previous corresponding periods, these companies reinvest profits for expansion rather than paying dividends, and can outpace sector averages.
Earnings growth often leads to higher share prices, with faster growth resulting in quicker price appreciation. Alongside profits and revenue, successful growth companies share traits such as having a sizable market potential and cutting edge business models.
Accordingly, growth stocks attract investors who are hoping to make a profit on capital gains in the short term, with dividend income a potential outcome once major growth has been established.
Identifying Growth Stocks
Growth stocks typically possess niche patents or innovative technologies that have led them to gain substantial market share in existing fields, expanding into new sectors, or even pioneering entirely novel industries. This unique positioning grants them a competitive advantage, reflected in their elevated price-to-earnings ratios, and often results in a notably large market presence and a dedicated investor following who end up paying a premium in hope of future growth.
However, this means that growth stocks can see rapid declines if the company underperforms, or even if it doesn’t just grow enough..
Unlike value stocks, high-growth stocks tend to be more expensive than the average stock in terms of profitability ratios, such as price-to-earnings, price-to-sales, and price-to-free cash flow ratios.
As an extreme example, US$619 billion market titan – Tesla, is by all accounts still a growth stock due to its future expectations, despite delivering less than one million of the 66.7 million automobiles sold in 2021.
Growth Stocks in Australia
Rising interest rates in Australia can impact growth stocks, particularly those reliant on debt for expansion. This will possibly shift investor focus towards safer fixed income. Still, industries with solid growth potential might still draw investors even in the face of rising rates.
However, growth stocks could benefit if rates revert to historic lows.
Value
Value stocks trade below their intrinsic value, conversely due to market overreaction or temporary setbacks. Value stocks tend to offer investors cash dividends as they have less need for cashflow. These stocks are often deemed undervalued by investors due to market perception, making them affordable choices.
However, as they are priced below actual worth, value stocks could potentially yield superior returns. Some investors seek these undervalued opportunities for gains as the market corrects and recognises true value.
They attract investors seeking bargains due to lower fundamentals, and often provide dividends as the company has less need for capital for growth, in contrast to growth stocks that tend to rely on cash for development.
Why are some stocks undervalued?
Investor sentiment, lack of growth, market dynamics, negative news, or industry pessimism can cause stock prices to drop, creating discounted opportunities. Poor financial performance, management issues, or legal troubles can lead to undervaluation. Macroeconomic factors like economic state can also influence stock undervaluation, especially during recessions.
Unpopular sectors or smaller companies might be undervalued due to lack of investor knowledge. Stocks with less attention from analysts can trade below actual value, as investors might favour more popular stocks.
Growth Stocks vs Value Stocks: In Summary
A growth stock typically comprises early rising companies that may be yet to make profit. Investors buy them based on speculation that the company will eventually grow and shall have high future earnings. As such, growth stocks tend to be riskier investments as it involves aspects of future speculations although the potential return for investors tend to be much greater.
Sectors with growth potential, like emerging markets, healthcare, R&D, and technology, often host growth stocks. These businesses may have greater volatility because they are frequently in their early development phases.
In contrast, a value stock is more likely to be an established company that has been oversold by the market and is now trading lower than its worth. Value stocks are frequently linked to solid, well-established businesses that operate in dependable sectors and have steady revenues and earnings, such as supermarket chain stocks or mineral producers.
Because it is more likely to be a mature company, their development rates may be slower and they might have hit a point where they no longer need to grow as much anymore. Value stocks typically possess lower risk, but this also means that the potential shareholder returns on offer are probably lower.
Some essential valuation metrics to differentiate Growth vs Value Stocks:
Price-to-earnings (P/E) ratio
- The typical Australian market P/E ratio is around 15.1 but can change due to business conditions and the economy. A P/E below 15 might mean undervaluation, while above 15 could suggest overvaluation.
- Stocks with a P/E ratio of 20 to 25 are more likely to be considered growth stocks, as well as some well-established large caps expected to grow moderately
- P/E ratio alone doesn’t indicate good value. P/E is useful when comparing shares in the same sector. A seemingly low P/E might be high compared to rivals, meaning it may not offer actual value.
Price-to-book (P/B) ratio
- A share’s P/B ratio reveals the price investors pay for a dollar of a company’s net assets. A ratio of around 1 is fair, while under 0.5 suggests a potential value deal, with shares priced at less than half their book value.
Debt-to-equity ratio.
- Companies finance operations through loans or issuing shares. Debt-to-equity ratio gauges debt vs equity financing. Below 1 is safer, allowing asset sales during crises. Above 2 is riskier; crises may impair debt payment.
- A high ratio jeopardises shareholders due to unsustainable debt and possible default.
- Context matters. Some industries (e.g., airlines) are typically more leveraged, influencing acceptable ratios.
Important to note:
- Value stocks stick to traditional valuation metrics, and often have low price-to-book (P/B) and price-to-earnings (P/E) ratios.
- Growth stocks often use untraditional valuation metrics such as price-to-sales (P/S) ratio or the forward PE ratio. Rather than indicating present earnings or book value, these metrics depict forecasts for future growth.
Choosing between growth and value stocks relies on individual financial goals, risk tolerance, and dividend preferences. Diversification often involves a mix of both to balance risks and rewards.
Clara is a Business Reporter for The Sentiment.
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