Understanding Growth and Value Investing
Growth investing and value investing are two popular investing strategies. Growth stocks are expected to outperform the overall market with sturdy earnings growth. On the other hand, value stocks represent undervalued stocks that have the potential to generate a superior return when their values are realized.
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With growth investing, investors seek companies that reinvest money back to achieve high earnings growth. These companies have demonstrated above-average performance in terms of earnings in recent years and are expected to show similar results in the days to come, which in reality is uncertain. It is common for growth companies to have a zero-dividend payout ratio since they emphasize expanding through reinvestment. Thus, excess returns are invested in growth rather than being distributed to shareholders as dividends. When a company is performing better than its competitors or, let us suppose is launching a product that is expected to do well in the market, investors are attracted to invest in a growth-oriented company. It enables them to benefit from maximum capital gain realized from selling the stocks when the prices have sky-rocketed.
- Growth stocks are priced higher than other stocks in the same industry because investors are willing to pay more, with the expectation of selling them at an even higher price as the company continues to grow.
- Generally, growth companies show high earnings growth, which increases investor confidence and desire to invest in growth stocks.
- Price volatility remains high in growth stocks. The prices may rise or plummet any minute, depending on the ongoing news in the market. Hence, there is a higher risk associated with growth investing.
With value investing, investors opt for companies with good fundamentals. For some reason, these stocks are trading below the price analysts believe their actual worth is. In other words, their value is estimated with the help of financial ratios, which help analysts know whether the stock is undervalued or overvalued. The idea is to buy undervalued stocks and avoid purchasing overvalued shares. For example, the book value per share of ABC company is Rs 300. And, the current trading price of the stock is Rs 200. Since book value per share is theoretically the sum of money shareholders would receive per share if the company liquidates and pays off its liabilities, it is beneficial to purchase the stocks at Rs 200 per share as it is undervalued by Rs 100. Hence, the gist behind value investing is to purchase undervalued stocks with strong fundamentals in the hope that the prices will rise as the value of the stock is realized.
- Value stocks are priced lower than other stocks in the same industry since their true value is yet to be realized. Many analysts believe that the existence of value stocks is due to investors’ overreaction to events such as negative publicity, dissatisfying earnings, among others, and their belief that it will continue for the long term.
- Value stocks are undervalued and have strong fundamentals.
- They tend to systematically gain in terms of prices and retain their value over a long period. Thus, value stocks provide lower volatility and more steady growth in the long run.
Identifying an Undervalued Stock
One single factor cannot determine an undervalued stock. Some of the factors, among many, to look into are given below.
- Low P/E ratio: The Price to Earnings ratio helps us know whether the market price accurately reflects the company’s earning potential. A low P/E ratio translates to a low current stock price relative to its earnings and thus, hints at a probable undervalued stock.
- High free cash flow: The amount generated after expenses is known as free cash flow. Companies with relatively a low stock price but plenty of free cash flow could be an indicator of a good value stock.
- High dividend yield: If a company has a high dividend yield compared to its competitors, it could be a sign that its share price is undervalued. However, we ought to be careful since the company could be paying enormous dividends to overshadow something.
Which Investing Strategy is Better?
Looking at the historical performance of growth stocks and value stocks to evaluate the better investment strategy, different times have shown different results. The selection boils down to an investor’s investment goals, risk tolerance, and time horizon.
Risk and Reward
Value stocks prove to be less risky and less volatile compared to growth stocks, at least theoretically. It is because value stocks usually belong to established and well-known companies. Although the prices may not increase to the levels predicted by the analysts, investors have a chance to earn dividends and benefit from some capital growth.
Growth stocks are considered to be riskier because these stocks are priced higher in the market due to investors’ perception that the company can keep on generating great profit. If the company fails to do so, the stock prices can plummet any minute. Thus, volatility is the factor that makes growth stocks riskier in comparison to value stocks. For instance, a newly launched product that was expected to perform well turns out to be a bummer. In this case, the stock price of the company will plummet in no time.
At the same time, it is due to high volatility that these stocks are priced higher than other companies in the same industry. Thus, it is possible to make it big by having growth stocks in your portfolio, given that you have a high-risk tolerance. Growth investors have the highest potential to profit or suffer from a loss due to price volatility.
Both growth stocks and value stocks are suitable for investors that have a long-term time horizon. However, over shorter periods, their performance depends upon the current market trend. For instance, growth stocks generally perform better during bull markets or periods of economic expansion, while value stocks tend to outperform during bear markets or economic recessions. Thus, short-term investors should be aware of the market trend before choosing an investment strategy.
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