Almost every investor faces a bind: How to balance risk tolerance with the desire for profit? It’s not easy because one often comes at the expense of the other.
This balancing act is what many investors consider when buying shares of publicly traded companies: Go with flashy growth stocks, with their potential for higher returns but also high volatility, or buy beaten-down value stocks on the cheap with the belief that their true underlying value has been overlooked by other investors?
Of course, an investor doesn’t have to just pick just one or the other, and many use a combination of growth stocks and value stocks in an investing strategy. Although there are some similarities between the two, there are also many important differences to note when considering value versus growth stocks.
What are growth and value investing?
Growth investing is the process of buying shares in companies that are expected to outperform in the future, either in terms of earnings, sales, cash flow, or gaining market share from rivals—or creating an entirely new market. As a result, these investments can provide long-term capital gains for investors willing to wait for the growth and endure potentially large price swings. Titan strategist Myles Udland defines growth stocks as “shares of a company that is growing its revenues more than 20% a year and has grown at that pace for at least the last five years.”
Most growth companies tend to reinvest any earnings back into their business, rather than pay out dividends to investors. This is done to promote both short-term and long-term growth, but it also means that investors will likely not be able to lean on those stocks as a source of passive income.
Value investing, on the other hand, involves identifying companies with an undervalued share price—in other words, “a value stock is a company or a share that is trading basically below the actual value of the business,” Udland says.
The idea is that if an investor is able to identify one of these stocks, and purchases shares while they are still undervalued, the investor will profit when the share price eventually corrects. The risk is that the shares continue to trade at a discount because the company is in a slow-growth or shrinking industry.
What are the main differences between value stocks and growth stocks?
Here are some of the key differences between these two types of stocks.
As the name implies, a value stock is generally regarded as underpriced compared to its intrinsic value. The idea is that the stock price eventually will rise as a reflection of the company’s true value. The investor will profit from that rise because they purchased shares at a discount.
Growth stocks, on the other hand, aren’t typically underpriced. In fact, they may even be expensive compared to most other stocks or the broader market. That’s because they are generally shares of companies that are expected to gain value at an above-average rate in terms of earnings, revenue, cash flow or compared to the competition. Even though the investor purchased the shares at a fair market price—or even paid a premium based on an above-average price-to-earnings ratio (P/E)—the investor still expects to benefit from the stock’s rapid growth.
Shares of growth companies may be subject to large price swings, which could be caused by everything from stock market downturns to economic news or even unfounded rumors. Because these investments can be so volatile—and are usually purchased at a premium—they require investors to have a higher risk tolerance and often, a longer time horizon.
Value stocks, on the other hand, are purchased at a discount. This means that there is a lower risk of loss, but the trade off is that the market may never validate the investor’s belief that the company’s shares are undervalued.
Growth-stock companies don’t typically pay out dividends to investors, choosing instead to reinvest any earnings back into the company to promote further growth. As a result, these stocks won’t provide passive income for investors.
Value stocks, on the other hand, often distribute regular dividend payments to investors. This can make them a source of passive income for investors looking to increase their cash flow now or in retirement. These dividends can also be reinvested to further grow a portfolio without additional cash contributions.
Market capitalization of growth and value stocks
Growth and value companies may also be thought of in terms of market capitalization, or cap.
A company’s market cap is calculated by multiplying the total number of shares outstanding by the current per-share market price. So a company with 800,000 shares outstanding and a price of $400 per share would have a market capitalization of $320 million.
Both value and growth stocks can be found in large-cap, mid-cap, small-cap, and even micro-cap sectors, which are roughly classified according to the companies’ total market value:
- Micro-cap: $50 million to $300 million
- Small-cap: $300 million to $2 billion
- Mid-cap: $2 billion to $10 billion
- Large-cap: $10 billion and up
While these categories only tell one part of the story, they can be a possible starting point for determining a growth or value stock’s potential. For instance, micro- and small-cap sectors often include newer or growing companies with future potential—though they might just be smaller, niche brands. Large-cap corporations often are well-established with a long history—but they may still offer the potential for above-market growth.
A company’s market capitalization tells an investor what that company’s valuation is in a given period of time, but it doesn’t necessarily capture discrepancies between current and future values. This can apply to both growth and value stocks.
Although value and growth investors utilize two separate investing strategies, not all investors will want to focus their efforts on just one category. For that reason, many money-management firms have begun offering blended funds: a type of equity mutual fund that includes a mix of both value stocks and growth stocks.
Blended funds seek to offer the best of both worlds: the opportunity to invest in underpriced, lower-cost value stocks that will steadily appreciate over time, as well as higher-priced growth stocks that offer the potential to outperform the market. This also works to balance the risk for the investor by combining a range of stock volatilities.
The bottom line
Buying growth and value stocks are two distinct styles of investing, with different levels of risk. They differ from one another in many other ways, though both offer the potential for capital gains over time as a company’s market value increases.
An investor may choose growth stocks, value stocks, or even blended funds with combinations of the two as part of a balanced portfolio strategy. Which of the two an investor buys—or how much of each—depends on personal factors such as risk tolerance and time horizon.