Growth vs. value: What's the difference?

You can define individual stocks in many ways. Some stocks are defined by the industry in which they operate: banking stocks, utility stocks, technology stocks, and so on. Stocks are also measured by their size or market capitalization: large-cap, small-cap, or mid-cap.

Yet another way to differentiate one stock from another is by style or type. Some stocks are known as "growth" stocks; others are called "value" stocks. What's the difference between the two investment types?

Growth Stocks

Growth stocks generally refer to companies with above-average earnings potential compared to the market, as measured by a major benchmark, such as the Standard & Poor's 500 Composite Index. These companies typically have relatively high price/earnings ratios* but investors believe their lofty multiples are justified.

Growth companies with good prospects for above-average earnings typically have strong management, a solid financial foundation and a prudent business plan. Theoretically, if a company is growing faster than other businesses, its stock should outperform most other stocks, as well.

Growth companies usually reinvest a significant portion of their earnings in their businesses for future growth. Most growth companies pay a small dividend or none at all. In a promising growth company, particularly smaller growth companies, management typically owns a significant stake in the business.

Value Stocks

Value stocks refer to corporations whose market price does not reflect the intrinsic value of the business. The company typically operates in an industry that has been going through tough times or has experienced a setback, such as earnings that have failed to meet analysts' expectations.

One way to identify a value stock is by its price-earnings ratio; it will be lower than that of the broader market. Another way to pinpoint a value stock is by its dividend yield, assuming the company pays a dividend to its shareholders. Dividend yield is the percentage figure calculated by dividing the dividend rate of a stock by its current stock price.

Some investors are hesitant to buy beaten-down stocks, but many of today's growth stocks were once value plays. Take International Business Machines, for example. In the mid-1990s, IBM was having difficulty meeting analysts' earnings estimates. As a result, its stock price was under intense pressure. Just a few years later, in the late 1990s, IBM became one of the world's dominant companies again. Other large companies also have endured cycles in which their stocks have gone from being value stocks to growth stocks.

Growth stocks and value stocks go through periods where one outperforms the other. These periods usually last a couple of years. Growth stocks spent more time outperforming value stocks during the 1990s and value stocks have generally outperformed since 2000. Because the periods in which growth or value stocks outperform each other alternate so quickly, diversifying assets among both types make sense.

To find growth and value investments with good long-term potential, talk with your Financial Consultant. He or she can introduce you to a variety of stocks and mutual funds that may be appropriate for your personal financial situation.

Chris Barone

Branch Manager

Senior Vice President

Financial Consultant

D.A. Davidson Companies

Coeur d'Alene, ID 83814

(208) 667-1212

* Price-earnings ratio equals the market price of a stock divided by its annual earnings per share.

This article was authored by a third party. This article does not necessarily reflect the expertise of Chris Barone, Branch Manager, or D.A. Davidson & Co., Member SIPC.