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Growth Stocks vs. Value Stocks
Investors are often confused about the differences between
growth stocks and value stocks. The main way in which they differ is not in
how they are bought and sold, nor is it how much ownership they represent in
a company. Rather, the difference lies mainly in the way in which they are
perceived by the market and, ultimately, the investor.
Growth stocks are associated with high-quality, successful
companies whose earnings are expected to continue growing at an
above-average rate relative to the market. Growth stocks generally have high
price-to-earnings (P/E) ratios and high price-to-book ratios. The P/E ratio
is the market value per share divided by the current year’s earnings per
share. For example, if the stock is currently trading at $52 per share and
its earnings over the last 12 months have been $2 per share, then its P/E
ratio is 26. The price-to-book ratio is the share price divided by the book
value per share. The open market often places a high value on growth stocks;
therefore, growth stock investors also may see these stocks as having great
worth and may be willing to pay more to own shares.
Investors who purchase growth stocks receive returns from
future capital appreciation (the difference between the amount paid for a
stock and its current value), rather than dividends. Although dividends are
sometimes paid to shareholders of growth stocks, it has historically been
more common for growth companies to reinvest retained earnings in capital
projects. Recently, however, because of tax-law changes lowering the tax
rate on corporate dividends (through 2010), even growth companies have been
offering dividends.
At times, growth stocks may be seen as expensive and
overvalued, which is why some investors prefer value stocks, which are
considered undervalued by the market. Value stocks are those that tend to
trade at a lower price relative to their fundamentals (including dividends,
earnings, and sales). Value stocks generally have good fundamentals, but
they may have fallen out of favor in the market and are considered bargain
priced compared with their competitors. They may have prices that are below
the stocks’ historic levels or may be associated with new companies that
aren’t recognized by investors. It’s possible that these companies have been
affected by some problem that raises some concerns about their long-term
prospects.
Value stocks generally have low current price-to-earnings
ratios and low price-to-book ratios. Investors buy these stocks in the hope
that they will increase in value when the broader market recognizes their
full potential, which would result in rising share prices. Thus, they hope
that if they buy these stocks at bargain prices and they eventually increase
in value, they have the ability to make more money than if they had invested
in higher-priced stocks that increased modestly in value.
Growth and value are styles of investing in stocks. Neither
approach is guaranteed to provide appreciation in stock market value; both
carry investment risk. The return and principal value of stocks fluctuate
with changes in market conditions. Shares, when redeemed, may be worth more
or less than their original cost. Investments seeking to achieve higher
rates of return also involve a greater degree of risk.
Growth and value investments tend to run in cycles.
Understanding the differences between them can help you decide which may be
appropriate to help you achieve your specific goals. Regardless of which
type of investor you are, there may be a place for both growth and value
stocks in your portfolio. This strategy may help you manage risk and
potentially enhance your returns over time.
© 2007 Emerald Publications
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