In a park, one certain time. I had an interesting conversation with a stranger. He forgot his business magazine on a bench I was sitting on. His magazine was a sign we shared a common interest.
I got him engaged in a conversation. He was just starting out in the stock market. He told me how he usually got confused in understanding the difference between a value stock and a growth stock.
He made the mistake of making a growth stock seem like a value stock.
He would say to himself, growth stocks have strong earnings. Since the goal of every company is to make quick consistent profits and more sales, then growth stocks are meant to be value stocks.
But his ideology was wrong, it was a grammatical error. I had to explain it for him.
Every participant in the stock market have different styles and approaches but one agenda. That is to make money. Before you invest your money in any company you want to be sure of what you are buying.
Are you overpaying for a stock or buying it at a bargain price? It is also possible to buy a particular stock at a bargain price with a fast growth.
What is a Value Stock?
A value stock is a stock that is trading below the intrinsic value of a company. The share price of a company is compared to its fundamentals like earnings, shareholder’s equity, sales and dividends.
A value stock that has a lower price compared to its fundamentals is undervalued, which makes it cheap. Value investors are interested in cheap stocks with strong fundamentals.
The market temporarily fluctuates due to news and trading activities. They have a long term view. They believe the market will rise in future in accordance to its true worth.
NOTE: Sometimes value investors don’t buy stocks simply because they trade below its intrinsic value. The stocks must sell at a bargain price.
A good bargain price should not be more than two – third of the intrinsic value.
For example if a stock has an intrinsic value of $45. Its price should not be trading for more than $30.
Value stocks usually have an annual earnings growth between 5% – 12%. They don’t care about price fluctuations.
To know the intrinsic value of a stock you can use an intrinsic value calculator. Value investors check metrics like price to earnings ratio, Price to book value ratio, price to sales ratio, dividend discount model, PEG ratio etc
A value stock can be any size of company. Example of some large cap value stocks are Coca Cola, Johnson & Johnson, Procter and Gamble.
There were also some growth stocks that transitioned into a value stock. A good example is IBM.
Pros of value stocks
- Value stocks are cheap relative to its fundamentals.
- Investing in value stocks is a risk averse approach.
- The markets are fairly less volatile than growth stocks.
Cons of value stocks.
- It can be difficult to find quality undervalued stock. But with a good stock screener you can find any kind of stock faster.
- Buying an undervalued stock at a bad timing, the share price might still keep on falling or range over time.
What is a Growth Stock?
A growth stock is not an overpriced stock. This mistake is common amongst beginner investors.
Though it is can be overpriced, please be guided. A growth stock is a stock with fast and higher future potentials expectancy to outperform the average value of its industry.
Growth stocks generates much positive cash flow. They make quick sales. They make higher earnings.
These higher earnings causes a lot of demands for its shares thereby shooting its share price to new highs, a high above its intrinsic value.
Growth investors check metrics like quarterly and annual earnings growth, Return on Equity, profit margins, Debt to Equity, new industries, products/services, customer loyalty etc.
A growth stock can be an emerging company with some new style or technology making consistent revenues beating their previous earnings. Growth stocks are usually large cap stocks because they are always investing retained earnings in new ideas and concepts Examples of some growth stocks are Google and Amazon.
Pros of growth stocks.
- When analysis is done well, growth stocks results in exceptional capital gains.
Cons of growth stocks.
- Growth stocks are often overpriced relative to its fundermentals.
- Growth stocks are highly volatile.
- Growth stocks are risky. Most times they end up being a bubble.