Analyzing Investment Styles: Growth vs. Value

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 at mutual funds that focus on growth stock. Value investors look for stocks that are currently undervalued and should increase to their true value during a longer time horizon, or at mutual funds with similar objectives.

Growth Fundamentals

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 or they offer proprietary niche products or services, have well-known brand names, strong finances, and top managements. They have superior profit margins and generally high (over 15%) return on shareholders equity. They almost never pay dividends, preferring, instead, to plow earnings back into the company.

Two key indicators of growth stocks are share price and earnings. Specifically, the earnings growth rate is generally 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 should 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 one 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 found by dividing the current share price by the earnings estimate, tells 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 should be considered. Ideally, the P/E should be lower than the earnings growth rate, for example, 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 real value investor will 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.

Note: Stock and mutual fund values will fluctuate due to market conditions; shares, when redeemed, may be worth more or less than their original investment. Profits and protection against losses due to declining markets are not guaranteed.

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