Growth or value—what’s your style? Growth investors look for stocks that will grow at a high rate for a relatively short period of time or index funds that focus on growth stocks. Value investors look for stocks that are currently undervalued and are expected to increase to their true value over a longer time horizon or index funds that focus on value stocks.
Growth investors seek companies that show consistent earnings and sales growth, usually 25% or more each year, for a three- to five-year period. Typically, the companies represented by these stocks are in rapidly expanding industries; they offer proprietary niche products or services; or they have well-known brand names, strong finances, and top management. They have superior profit margins and generally high (over 15%) return on shareholder equity. They seldom pay dividends, preferring, instead, to plow earnings back into the company.
Two key indicators of growth stocks are share price and earnings. Generally, the earnings growth rate is the more important of the two indicators for growth stock investors. It is the rate at which profits grow from year to year. Generally, growth stocks have an earnings growth rate over 25%. Consistency is also important. The market will not place as high a value on a company whose profits are up 40% one year and down 10% the next, as on a company that grows 25% year after year.
Another key indicator for growth investors is stock price relative to the earnings or price to earnings (P/E) ratio. The P/E ratio, which is determined by dividing the current share price by the earnings estimate, represents what the market is willing to pay for a share of the company’s earning power. Although a growth investor may be willing to buy a company sporting a high P/E ratio, some relative guidelines may also be considered. Ideally, the P/E should be lower than the earnings growth rate, such as a growth rate of 45% selling at a P/E of 30%. It is also a good idea to look at a stock’s P/E in relation to the average P/E for its industry and relative to the market as a whole.
Value Investing—Key Indicators
Unlike the growth investor, a value investor typically buys a stock that has a P/E ratio substantially below that of the general market, the relevant industry, and the earnings growth rate. Value investors look for companies that are cheap relative to their “book value.” Book value is the difference between a company’s assets and its liabilities. It is theoretically the value of the portion of the company represented by a share of stock. Book value divided by the current market price, or price to book, shows the multiple that the market is willing to pay for a portion of the company’s assets.
Generous dividend payments, or a high yield, are also important to value investors. Since dividends account for half of a stock market’s long-run total return, a stock that has a higher yield will give a value investor an edge over other investors. A value investor expects the price of a stock to rise to its true value, a predetermined target. When the target or the “appropriate” value is reached, a value investor may sell that stock and look for another selling at a discount.
While some investors favor growth investing and others favor value investing, there are those who use both styles in their portfolios. The best strategies for your situation will depend on your risk tolerance, time horizon, and investment objectives.