Value vs Growth – Karol's Blog

Analysts like to categorize stocks as either value or growth. This is done with the caveat that some stocks resemble both types, or cannot be clearly categorized as either. Knowing the difference between two is essential to assess the risk and the opportunities for your portfolio.

This article will briefly introduce characteristics of growth and value investments. It will also clarify what are desirable outcomes for growth and value investors, what are the risks and more importantly the opportunity costs for both investment styles. Let’s start with a simple description.

Growth Stocks

Shares of the companies that are experiencing above-average growth. They might have low or negative earnings and pay no dividends as most of their income is reinvested back in their operations, to fuel the further revenue growth.

Companies can become a growth stock due to the introduction of innovative products, creating new markets or reinvesting existing one. Or simply due to outstanding operational efficiency and the effective business model.

Value Stocks

Shares of the companies that have fallen out of favor which drove its price below the intrinsic value (therefore representing ‘good value’ or bargain). They usually still have a good fundamentals, business model and remain competitive but require a catalyst to reignite investor’s demand and increase their valuation.

Company can become a value stock due to sector or market correction, public perception and sentiment, discount caused by unrealized risk, improvable operational missteps, negative and exuberant momentum.

Some securities ofcourse won’t match either of the descriptions above. In fact in the developed market you would find that the majority of securities are fairly valued (at their intrinsic value) and are growing at a stable, average pace. Those securities are usually a better representation of the broader market and play a major part of the broadly diversified portfolio. You can find many attempts to loosen value and growth definition, in order to fit those stocks into either of the categories. In my view this distorts categorisation and blurs the reasons for holding those securities in the first place. This can also compromise our portfolio objectives by being vogue about specific risks and opportunities for each security.

Below I’ve described key opportunities and risk associated with value and with growth stocks.

	Value	Growth
Opportunities	Superior returns due to purchasing company’s shares below what they are really worth Value investor must be right while the stocks market is wrong – fundamental stock analysis correctly identified that intrinsic value is higher than current market capitalization	Superior returns due to realization of it’s future above-average growth potential, which is currently not recognized by the market
Risks	Market is right and stock is cheap for a reason. Shares either remain at current levels or decline further.	Overestimating growth potential Growth attracts competition which contracts profit margins

In practice different analysts and portfolio managers have slightly different rules to assign stock to either growth or value category. Those rules can also differ depending on the market (developed, merging, frontier) and sector. Having that in mind, see below table where I have outlined more commonly used characteristics for both categories. I have explained how they apply to boh investment types and added brief, simplified definitions to help you grasp the concept.

	Value	Growth
Multiples Offer an easy, quick gauge of the company’s relative valuation. Simplistic with low reliability. On average they are low for value and high for growth companies.
P/E Price / Earnings (Net Profits) How many year it would take to repay your investment in the company, assuming current profitability of its operations	Determines how many dollars (or other currency) investors are currently paying for each dollar earned by the company – value investment is focused on those predictable results. Most widely-used multiple to determine relative valuation as it helps with standardization – different industries have different average P/E ratios, but regardless of industry every company is in the business of earning money for the shareholders. Compare with peers and recent historical levels to ensure relevant reference levels. Generally the less you pay for potential earnings the better, but P/E ration might be deflated due to cyclicality of the business or non recurring income Companies with low P/E ratio are less likely to grow in the future, thus watch out for the ‘value traps’.	Future earnings power is more important than the current earnings Meaningless for young growth companies or startups with net operating losses or low erratic earnings (as long as there is a clear, predictable path to future profitability) Cannot be calculated for the company without earnings or its giving meaningless number in case of net losses Would be relatively high for the majority of growth companies with rapidly growing revenues – growing earnings are more valuable than stable ones, thus P/E is higher. Forward P/E should be used with caution – a company may understate earning estimates to easily beat it next quarter or to overstate it to assure investors that it’s on the right growth trajectory. Companies with high P/E ratio are more likely to grow in the future, but watch out for the unrealistic growth projection and competition
P/S Price / Sales (Revenues) How much the market values every dollar of the revenues company has made and reported in last 12 months	Low relative to its pears. Must be coupled with looking at the profit margins. Watch out for levered companies and debt-burdened sales (low P/S due to collapsed market cap). Help to spot recovery Situations.	Ensure high multiple is supported by the high growth prospects. If very high, check if the growth indicated by the valuation is realistic (how big, the company needs to become, how many customers it needs to serve in order to justify this multiple. How realistic is that given the competition). Userful for young, growing companies with erratic earning or no earning. More reliable indicator of growth than earnings. Sales is valuable only if it can be turned into profits at some point – ensure you understand the path to profitability (how a company can get to that point).
P/B Price / Book Value (Equity, Carrying Value) Compares the cost of buying equity of a company to value of the company’s net assets if company would be broken up and assets sold	Low relatively to it’s pears How high is the price we pay, relatively to the value of a tangible net asset of a company Usually anything below 1 is considered a value investment Anything above 1 need to be explained by relative competitiveness, identifiable value of intangible assets. Watch out for cases where stated value of the company’s assets are exaggerated. Highly unreliable as based solely on balance sheet, need to be paired with return metrics and other ratios for any insights.	Can be mostly ignored when analysing growth stocks Especially impractical when dealing with innovative companies with emphasis on human capital, R&D, patents and other intangible assets
P/CF Price/Cash Flow Share Price per Cash company is generating from it’s operations over last 12 months	Useful for not profitable companies because of their large non-cash charges. Useful in addition to P/E ratio, as it’s adding back non-cash expenses such as depreciation and amortization to net income. More reliable as the cash flows cannot be manipulated as easily as earnings. It level depends on company’s industry and company’s investment needs or maturity	It’s based on operating cash flow which for growth companies is often negative (operations are funded by borrowing), thus could not be used
Financial Statement Interpretation of Financial Statement is absolutely critical for Value Investor – your advantage or disadvantage relative to other investors, is directly related to the depth of understanding of the company’s Financial Statement. For growth investors it helps to understand the current financial position and base of future growth.
	Critical for Value Investing which focuses on all parts of the Financial Statement in order to derive Intrinsic Value of the company. Company’s present financial position and its past earnings record are prerequisite to gauge its future possibilities It’s worth to start from understanding: Profitability ratios Assets Value and Balance Sheet strength Working Capital dynamics Cash Accounts Intangible Assets	Important for Growth Investors which focus most of the analysis on the Income Statement – how revenues are translated into profits It’s critical to understand how this is changing over the years – growth trajectory and path to profitability
Beyond the numbers Multiples and Financial Statement cannot paint the full picture that is required to make a thorough investment decision. Knowledge of the product, market, competition as well as forces, factors and institutions affecting the business environment are also important. Especially for the growth investor.
	Most important part is to understand in depth all the factors that caused business to be undervalued in the first place (are those threats factual and lasting – company ‘cheap for a reason’) For value investor who mostly focus on identifying and understanding the moat around the business, that protects it from the competition – ensure business has advantages that allow it to at least survive	Growth investment analysis is less formulaic as most of the value is derived from the future Business valuation must go far beyond financial statement which during the growth phase can change significantly from quarter to quarter Understanding the product and its value proposition is critical Competitor analysis and industry specific knowledge is critical Analysts usually covers only one to three sectors (a circle of competence) Understand the micro environment that affect the performance of the company

Conclusion

It is important to be aware of the basic characteristics of value and growth styles and being able to identify if the company which shares we would like to purchase can be classified into either of those two categories. Classifying investment, will help us recognize risks, and opportunities and to clarify what drives their returns. It will also make our research more effective by helping to focus on the most important aspects.

To learn more about value and growth investments and to identify companies to buy from each category, I strongly recommend two investment classics. Those books have been helping generations of investors to become more prosperous, and are still on the recommendation lists of many most successful portfolio managers of our generation. I strongly recommend getting your own physical copy as both books are not only an important read, but also a guide to which you want to refer to many times on your investment journey.

For growth investments – “The Intelligent Investor” by Benjamin Graham
For value investments – “Common Stocks And Uncommon Profits” by Philip A. Fisher