Equity securities are generally categorized as either value style or growth style, although a stock can have properties of each. Value style can be defined by many different metrics, but generally speaking a value investor is looking for stocks where the aggregate price (market capitalization) is less than what that investor believes to be the intrinsic value of that company. Intrinsic value is often derived from a standard price multiple of various accounting measures or other company metrics. Commonly used price-multiples include price divided by earnings (P/E), price divided by book value of assets (P/B), and price divided by sales (P/S), among other variations.
The value style of investing often represents older and more mature companies and are often dividend paying stocks as well. Certain sectors are also traditionally considered to be mostly value style stocks including utilities and financial/bank stocks. While these associations are common, the fact that a stock is of a certain sector does not inherently categorize it as that sector’s traditional investment style.
Investors should further be aware that many stocks could be categorized as a value stock for good reason and thus may tend to be more risky than otherwise. Examples can include stocks which may have recently been profitable, however have realized a decline in stock price over speculation of poor company/industry outlook, lower expected future earnings, damaging litigation, government regulation, or increased industry competition. It is important to be highly diversified even within an asset class or sub-class to mitigate these individual company risks.
How does value style differ from growth style? While value investors tend to focus on the current price of the company, growth style investors tend to be more interested in the future potential for significant increase in revenue and/or earnings. Because growth style companies have less emphasis on current profitability, and because their price often reflects the market’s expectations of growth in future revenue/earnings, their price multiples (P/E, P/B, and P/S) are often much higher than an average stock. The belief is that if earnings grow significantly in the future, then the price will naturally follow. The higher the probability this will occur, the more this will be reflected in current stock price.
Growth style companies are less likely to be paying a current dividend, often because they are not yet profitable or they are focusing reinvestment of their earnings back into research and development of new products or services. The industry most commonly associated with growth style investing is technology, however truly a company from any industry can be considered growth. The primary risk of growth style companies is that the company may never achieve its speculated potential to grow.
Both value and growth investing labels are not mutually exclusive—that is a company can be both reasonably priced relative to an investor’s estimated intrinsic value and also have expectations of significant future growth in sales or earnings. Often times these stocks are labeled “core” or “blend” style.
Why is this distinction between value and growth important? It is important to understand if a stock is growth style or value style (or a little of both) for two primary reasons. First, it may be better to understand the style in order to help set expectations for return, volatility and correlation—ultimately using this information to categorize the security into an asset class and build your portfolio’s asset allocation. Second, it would be helpful for performance evaluation. In order to appropriately benchmark the returns for a stock, it is important to correctly identify the style to ensure a fair and accurate “apples to apples” comparison.