If you’re new to investing and are trying to decide which style of investing makes sense for you, it can be very easy to feel overwhelmed by all of the different options. There’s active investing vs. passive investing, ESG investing vs. values-based investing, large cap investing vs. small cap investing—the list goes on.
Two styles of investing that are often pitted against each other are value investing and growth investing.
Below, we’ll take a look at what makes a stock a growth stock or a value stock and explain how both value investing and growth investing work. We’ll also offer some guidance to help you decide how growth and value stocks may fit into your financial plan to best empower you to reach your financial goals.
What are value stocks?
A value stock is any stock that appears to be cheap compared to the underlying fundamental value or performance of the company.
Generally speaking, value stocks tend to be well-established companies that operate in secure industries, such as finance. They are also more likely (though not guaranteed) to pay dividends than growth stocks.
Analysts and investors use a lot of different financial metrics to try to identify stocks that fit into this mold as a value stock. These metrics can include a company’s price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, debt-to-equity (D/E) ratio, dividend yield and free cash flow.
Value stocks often have a low price-to-earnings ratio, low price-to-book ratio, low debt-to-equity ratio, high dividend yield and high free cash flow—especially compared to their historical performance, industry benchmarks or competitors.
How does value investing work?
Value investors specifically look for stocks that they believe trade for less than what they are really worth.
They purchase these shares when they are undervalued in the hopes that the market will eventually realize their true fundamental value and the share price will rise. At that point, a value investor may then sell shares for a profit or continue holding them to collect dividend payments (if the shares pay dividends).
Of course, there are risks to value investing. This includes the possibility that a company’s shares are not undervalued and that they are trading at a discount for a legitimate reason—a situation known as a “value trap.” In these cases, the share price may never rebound as the value investor thinks it will or may take a long time to do so.
What are growth stocks?
A growth stock is a company that is currently experiencing (or expected to experience) exceptional growth. This growth can be measured in a number of ways, including user growth, market share growth, sales growth, revenue growth and more.
Growth stocks tend to be smaller companies with the potential to grow into larger companies (although they can be large companies, too). Today, they’re often found in the tech industry or other industries that see a lot of innovation or disruption. That being said, growth stocks are found in all sectors of the economy, and some of the largest companies in the world by market cap are, in fact, considered by many to be growth stocks.
Growth companies typically prioritize executing on their long-term plans over short-term profits, reinvesting revenue and earnings to accelerate growth. With this in mind, most growth stocks do not pay dividends. They also often trade at a high P/E ratio compared to their benchmarks and other well-established competitors operating in the same industry.
This high P/E ratio is the reason that growth stocks often look expensive when compared to the general market—and especially expensive compared to value stocks.
How does growth investing work?
While value investors choose investments based on how “cheap” they appear to be, growth investors choose investments based on the future potential of a company. If the company succeeds in realizing this potential, the expectation is that the share price will eventually reflect this fact—at which point the investors can sell their shares for a profit.
Value investors often enjoy dividend payments while waiting for their shares to appreciate in price. Growth investors can’t count on these dividend payments and typically realize a profit only when they eventually sell their shares at a higher price.
The primary risk of growth investing is the fact that a company may not be successful in executing its plans. In the worst case, a growth company may go bankrupt before reaching profitability, resulting in a total loss of capital for the investor.
Which is right for you: value or growth?
The answer to this question will depend largely on your investment timeline, risk tolerance and investment goals.
If you have a long investment timeline, can tolerate a high degree of risk and have aggressive target returns, you might find growth investing to be an attractive investing strategy.
On the other hand, if you have a shorter investment timeline, don’t tolerate risk well and have more conservative target returns, you might find that value investing better aligns with your situation. Similarly, if you are looking to generate income from your portfolio now, you may find greater success through value investing as opposed to growth investing, simply because value stocks are more likely (though not guaranteed) to pay dividends compared with growth stocks.
But the truth is, value investing and growth investing don’t need to be at odds with one another. In fact, for most investors, a diversified portfolio that contains a mix of both value and growth stocks will likely make more sense than a portfolio consisting entirely of one or the other.
How to get started
Whether you choose to embrace value investing, growth investing or a mix of both, it’s important to always keep an eye on your asset allocation so that your portfolio is not overly concentrated in too few assets.
A great way of doing this, especially for new investors, is by investing through funds. Funds, like index funds, exchange-traded funds or mutual funds, contain a variety of different stocks, making it very easy to quickly diversify your portfolio among hundreds or even thousands of different companies and other investments.
Not sure which investment strategy is best for you? A financial advisor can help you understand your options and craft the investment portfolio that best matches your timeline, risk tolerance and financial goals. An advisor can also show you how additional financial tools can work with your investments to help you feel more confident about reaching your financial goals.
No investment strategy can guarantee a profit or protect against loss. All investing carries some risk, including loss of principal invested. Past performance is no guarantee of future performance.