Investors often speak of value and growth investing as the primary methods of choosing profitable stocks. Value investing refers to purchasing shares of a distressed company which have fallen below its intrinsic value, while growth investing refers to investing in a companies trading above its intrinsic value with high growth rates. Let’s discuss the differences between these two investing strategies.
Value investing, as defined by Warren Buffett’s mentor Benamin Graham, is defined as purchasing shares of a company when the share price approaches or drops below its book value. The book value is defined by the amount of cash equivalents a company has on hand for each share. For example, if ABC company has $ 100 on hand, and it has issued 100 shares of stock, the book value would be $1 per share. At $1 per share, the book value is 1. if the company reports great earning and investors bid the stock up to $5, the book value is now 5. If the company performs poorly and the stock price falls to $0.50, the book value is now 0.5 Graham instructed investors to invest in stable companies with a book value under 1, as share of companies with healthy balance sheets would eventually climb back towards book value if its assets did not continue to deteriorate.
Value investors also look for stocks with low trailing and forward P/E ratios. P/E stands for the Price to Earning ratio, which is calculated by dividing the share price by the quarterly earning per share. Trailing P/E refers to the ratio in reference to the previously reported earning per share, and the forward P/E is calculated with the company’s guided EPS for the next quarter. Acceptable P/E defers from sector to sector, tech stocks may have higher P/Es due to slower growth rate, while utilities stocks will have lower P/Es due
to slower growth. A low P/S, or price-to-sales, ratio is also desirable for value investors. The P/S ratio is calculated by dividing a company’s share price by revenue per share. Similarly to the P/E rato, a lower value would signal that the stock is undervalued. Both the P/E and P/S ratio should only be used to compare a company with its industry peers, and not across different sectors.
When a company’s stock is distressed and its dividend yield does not change, Lucrative opportunities in income investing emerge. For example, if stock XYZ once traded a $20 per share, paying a quarterly dividend of $1 a share, and the stock price plunged to $10 per share while maintaining the same dividend, the yield has now increased from 5% to 10%.
Value investors search for these damaged dividend stocks with the aforementioned technical qualities, since they will pay them to wait out near term volatility. This investing strategy generally work well at the nadir of bear markets and is best defined by the timeless Buffett proverb, “Be fearful when others are greedy, and be greedy when others are fearful.”
Growth investing is the practice of chasing stocks with high growth rates, often accompanied by high P/E ratios and volatility.
While value investors search for stocks which have fallen near book value, growth investors often see this approach as slow and conservative. Growth investors chase the winners in the market and bid them higher, as seen in stocks like Google or Apple during the past decade. Often times these stocks will defy the technical laws of P/E and book value while posting record gains in sales and margins.
Growth investors are concerned with a compnay’s ROE, or return on equity. This is the amount of net income which is generated, percentage-wise, by the shareholders’ invested cash, and the higher the better. Growth companies, especially tech ones, often receive huge cash infusions from speculative shareholders. A failure to check the ROE while buying into the hype generated by financial media can result in a blind investment. A prime example of blind growth investing was the dot-com bubble of 1995-2000, when tech startups generated large amounts of capital from shareholders without any revenue to back up the shares.
Growth investors also watch for increasing operating margins. As long as the margins steadily increase, the company’s profitability is expected to increase. Declining margins will cause growth investors to sell the stock, as it signals that a period of growth has ended with stagnation or decline. Margins should only be compared to industry peers producing similar goods or services.
Growth stocks tend to not offer dividend. In the tech industry, announcing a dividend is seen as a transition from a growth company to a mature one, a label which many growing companies seek to avoid. Growth investing is usually recommended for younger investors with a longer time frame to ride the near-term volatility.