Understanding Growth Stocks vs. Value Stocks in Investing

In the world of finance, the terms "growth stock" and "value stock" are frequently used to categorize and analyze different types of investments. Investors often find themselves torn between these two options, each offering its own set of opportunities and risks. In this article, we will delve into the intricacies of growth stocks and value stocks, exploring their definitions, characteristics, and what sets them apart.

Defining Growth Stocks

A growth stock is any share in a company that is anticipated to grow at a rate significantly above the average growth for the market. Unlike value stocks, these stocks generally do not pay dividends. This is because the issuers of growth stocks are usually companies that want to reinvest any earnings they accrue to accelerate growth in the short term. When investors invest in growth stocks, they anticipate that they will earn money through capital gains when they eventually sell their shares in the future.

Key Takeaways:

• Growth stocks are those companies expected to grow sales and earnings at a faster rate than the market average.
• Growth stocks often appear expensive, trading at a high price-to-earnings (P/E) ratio. However, such valuations could actually be cheap if the company continues to grow rapidly, which will drive the share price up.
• Since investors are paying a high price for a growth stock based on expectation, if those expectations aren't realized, growth stocks can see dramatic declines.
• Growth stocks typically don't pay dividends.
• Growth stocks are often put in contrast with value stocks.

Understanding Growth Stocks

Growth stocks may appear in any sector or industry and typically trade at a high price-to-earnings (P/E) ratio. They may not have earnings at the present moment but are expected to in the future. Investment in growth stocks can be risky. Because they typically do not offer dividends, the only opportunity an investor has to earn money on their investment is when they eventually sell their shares. If the company does not do well, investors take a loss on the stock when it's time to sell.

Growth stocks tend to share a few common traits. For example, growth companies tend to have unique product lines, patents, or access to technologies that put them ahead of others in their industry. In order to stay ahead of competitors, they reinvest profits to develop even newer technologies and patents as a way to ensure longer-term growth.

Because of their patterns of innovation, they often have a loyal customer base or a significant amount of market share in their industry. For instance, a company that develops computer applications and is the first to provide a new service may become a growth stock by gaining market share as the only provider of this service. If other app companies enter the market with their own versions of the service, the company that manages to attract and hold the largest number of users has a greater potential for becoming a growth stock.

It's important to note that while many small-cap stocks are considered growth stocks, some larger companies may also be classified as growth companies. You can find growth stocks trading on any exchange and in any industrial sector, but they are more commonly found in the fastest-growing industries and on innovative exchanges like the Nasdaq.

Differentiating Growth Stocks from Value Stocks

Growth stocks differ from value stocks in several key ways. Investors expect growth stocks to earn substantial capital gains as a result of strong growth in the underlying company. This expectation can result in these stocks appearing overvalued because of their generally high price-to-earnings (P/E) ratios.

On the contrary, value stocks are often underrated or ignored by the market, but they may eventually gain value. Investors also attempt to profit from the dividends they typically pay. Value stocks tend to trade at a low price-to-earnings (P/E) ratio.

Some investors may try to include both growth and value stocks in their portfolios for diversification. Others may prefer to specialize by focusing more on value or growth.

Characteristics of Value Stocks

Some value stocks are underpriced simply due to poor earnings reports or negative media attention. However, one characteristic that they often have is strong dividend-payout histories. A value stock with a strong dividend track record can provide reliable income to an investor. Many value stocks are older companies that can be counted on to stay in business, even if they aren't particularly innovative or poised to grow.

Example of a Growth Stock: Amazon

Amazon Inc. (AMZN) serves as an illustrative example of a growth stock. Amazon has long been considered a growth stock and is one of the largest companies globally. As of September 24, 2021, it ranked fourth among U.S. stocks in terms of its market capitalization. Amazon's stock has historically traded at a high price-to-earnings (P/E) ratio, ranging from around 58 to 106 between June 2020 and September 2021. Despite the company's size, earnings per share (EPS) growth estimates for 2022 are over 67%. When a company is expected to grow, investors remain willing to invest, even at a high P/E ratio. The risk is that growth doesn't continue as expected, leading to a dramatic decline in the stock's price.

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