What are the differences between value and growth stocks?
Looking to get into investing? Find out the differences between value and growth stocks.
When trading assets on the stock market, investors will have the option to buy into growth or value stocks. The two concepts each have their own unique characteristics, but fortunately, they do tend to complement each other, so day traders generally look to include both of them when building a balanced portfolio.
The main difference between value and growth stocks is that the former are usually classified as larger companies that are currently trading below what they are worth but have the potential to provide ample returns in the future. The latter are usually start-ups or smaller companies that have great potential and could outperform the overall market in the long term.
However, it is important to note that the context of an individual investor’s strategy, their willingness to take on risk, and whether they are targeting short-term or long-term gains can define whether a particular asset should be traded as a growth or value stock.
What characterises a value stock?
Stocks defined as ‘value’ are priced lower than the broader market but are not necessarily cheap to buy into. Investors target value stocks because they believe that certain companies are capable of rallying from a low point and then trading higher over time. A company may become a value stock if it has solid fundamentals but has recently posted a disappointing earnings report.
When the wider market ‘overreacts’ to negative news developments or issues in this way, value stocks are essentially created. These stocks are usually priced below other companies in an industry. Investors enter the market and buy value stocks before a market correction increases the price.
To help identify value stocks, you can analyse the price-to-earnings ratio (P/E), price-to-earnings growth ratio (PEG), and book value. If a company’s stock has a $35 book value and is currently trading at $27.50, it would make sense to buy into that stock. You can use analysis on a daily basis to determine whether a stock is undervalued or overvalued.
Because value stocks are usually larger, more established companies, they carry less risk compared to growth stocks that may have only recently listed as a public company and could struggle to capitalise on early potential. Value stocks are also more suited to long-term trading styles as it can take a while for gains to be realised.
What characterises a growth stock?
As the name suggests, a key characteristic of a growth stock is the potential for strong growth. These stocks are often smaller companies with a unique selling proposition that have already been able to sustain expansion on a regular basis. However, both medium and large-cap companies can also be growth stocks, though they do tend to grow at slower rates, so this is something to keep in mind.
Investors usually look for growth rates of 10% or more over a five-year period. They also keep a keen eye on return on equity, earnings per share, earnings before taxes, and projected stock prices before buying into a company. However, a stock does not have to excel in all of these areas to be considered a viable growth stock. The context of the industry, competitors, product offering, and other factors should be taken into account.
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Which is the better option?
Both value stocks and growth stocks have outperformed each other against the market at some point during the last 20 years. While your trading style, risk exposure and financial targets will dictate what stocks you should target, there should be room for combining both value and growth assets in your portfolio.
This is part of diversifying your assets and hedging risk to cater to the cynical nature of the stock market. Value stocks can really take off when economic recovery is underway but can stagnate when share prices are always rising, while growth stocks can struggle during an economic downturn.
By considering all of these factors and comparing the performance of growth and value stocks, you can make an informed decision and give yourself a better chance of delivering high returns with less risk from your investments on the stock market.