What are Growth and Value stocks and how to recognize them

Value stocks are stocks that look undervalued when compared to the market on multiples like P/E (Share price vs Earnings per share), P/B (Share price vs Book value per share), or dividends per share. Stocks that are overvalued according to these multiples are called Growth stocks.

Value stocks are stocks that look undervalued when compared to the market on multiples like P/E (Share price vs Earnings per share), P/B (Share price vs Book value per share), or dividends per share. Stocks that are overvalued according to these multiples are called Growth stocks.

In other words, companies which stocks have a low price compared to their earnings per share (P/E) in regards of the market average are said to be Value stocks. On the contrary, stocks that have a high price compared to the current earnings are said to be Growth stocks. So Value stocks have a low P/E and Growth stocks have a high P/E. Another common feature of Value stocks versus Growth stocks is a low Price-to-Book value ratio. This means that the price of a Value stock is undervalued compared to the book value of the assets allocated to each shares.

This definition actually translates a simple rationale for the investor:

Growth stocks:

  • Companies which are expected to generate a high growth in the future will have a high P/E ratio, because the price reflects the high future (expected) earnings, not the current earnings which can be quite small.
  • The Price-to-book value ratio can be high because of the limited quantity of assets in the balance sheet.

This is typically true for a young tech company for example, and more generically for any company expecting a fast future growth. Investors buy this stock because the stock price is expected to increase in the future, when the higher earnings are announced. Most of the return on these stocks comes from the capital gain created by the future increase in stock price.

Value stocks:

  • Value stocks on the other hand are shares of companies that are not expected to grow much in the future.
  • These companies usually distribute a high and rather stable dividend that constitutes the largest part of the total return on these stocks.

As a consequence, the price of the stock is largely based on cash flows that are close (the next dividend payments) and hence more certain and less risky, while the price of the Growth stock massively depends on remote cash flows that are expected when the company business picks up. As a consequence, it is then commonly admitted that Growth stocks are more risky than Value stocks. Should the business forecast be revised down, the Growth stock price would suffer more than the Value stock price.

Below is a typical break-down of equity share prices by main components for Growth and Value style stocks:

Exampl components of the Value and Growth style stock prices

Investment rationale:

  • The rationale for investing in a Value stock is often that the stock is seen as undervalued and that the price should increase when the market recognizes the potential of the company.
  • In contrast, Growth stocks are often considered to be over-valued.
Matthieu Liatard
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