There are many ways to categorize stocks. One of the most common is the dichotomy between “growth” and “value.” So, what makes a stock a “growth stock” or a “value stock?"
When we buy a share of a company, ABC Acme Corp. as an example—we are buying partial ownership of ABC Acme’s future earnings. This entitles us to any dividends they declare, the ability to re-sell our share on the open market, and vote on various issues related to the company. The price of ABC Acme’s shares will be based on public perception of the company, their ability to continue growing, and what people think future earnings potential will be. Depending on stock price and corporate earnings, ABC Acme will have a few commonly used metrics to measure its attractiveness, one of the most prominent being the “P/E” Ratio ([Share] Price to Earnings), to measure the relative price of its stock compared to other companies.
“Growth stocks” are companies who most think will have substantial profits and earnings in the future. In some cases, they may not even be currently profitable. The prices of “growth” stocks are usually elevated when looking at metrics like Price to Earnings because the price is high relative to current earnings (or there may be no earnings at all). Many technology stocks are considered growth stocks because the public is inspired by their ability to make money in the future and are willing to pay more for a share today because of expectations. Companies in new industries, or with revolutionary technologies, are usually priced as “growth” companies.
“Value stocks” are companies whose business trade at lower multiples. This means their Price to Earnings ratios will be lower. Essentially, to buy $1 of earnings from a “value” company, you would expect a lower share price when compared to the rest of the market. “Value” stocks tend to be in less exciting industries with more mature business models and usually have more predictable cash flows than growth companies. Typically, this includes industries like consumer staples, utilities, and durable goods.
The growth and value moniker can also be used to compare stocks inside the same industry—there can be “value” technology companies or “growth” consumer goods companies. It’s important to remember that growth and value are both relative measures.
Growth and value both play their roles within a diversified portfolio and although market conditions may tilt in favor of one or the other, we like to have exposure to both inside of our portfolios, managing the mix over time. Growth stocks typically do better during the early and expansionary phases of the economic cycle, while value stocks tend to do better—because of their predictable cash flows and mature business models—during the more stressful phases of market cycles. Both styles can have their place.
This content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.