Stock Trading 101: Value Investing vs. Growth Investing
Stock trading isn’t done blindly, at least not by those who are successful in the markets. It takes planning – developing a winning strategy that identifies which stocks have the potential to go higher. You’ve most likely seen or heard of the most commonly used strategies already: growth investing and value investing. What you might not know is what the difference is and which one works best for your portfolio.
One of the most common misconceptions about stock strategies is that only one can be used at a time. But growth investing and value investing only apply to individual stocks, not an entire portfolio. One of the best ways to diversify is to mix up the types of stocks you hold in order to minimize risk and maximize profits. Understanding how each type works is your key to building your ideal portfolio.
The Value Approach
Value investing has a lot of popular practitioners on Wall Street, such as Warren Buffet and Peter Lynch making it a favorite for many beginning investors. The underlying idea is to spot stocks that haven’t reached their true potential yet with a stock price that’s discounted relative to it’s real value. It tends to be a low-risk approach that resonates with investors who dislike the idea of high-risk investment moves.
Value investing involves being able to figure out a stock’s intrinsic value. The most common key metrics used are the price-to-earnings ratio, price-to-book ratio, total debt level, dividend yield and payout ratio, and earnings growth.
Here’s how each metric is applied to a value stock.
Price-to-Earnings: This ratio is used to determine what multiple investors are willing to pay for the stock. The lower the figure, the cheaper the stock is relative to its future earnings potential.
Price-to-Book: This ratio tells investors how much the stock is currently trading for relative to its overall book value, or value of the company if all assets were liquidated. A low ratio tells investors that the company might be undervalued.
Total Debt Level: Value investors like to identify stocks that have a large cash flow and low debt obligations in order to spur future growth and avoid being saddled with high interest payments.
Dividend Yield and Payout: Most, but not all value stocks come with a dividend yield. It’s important that the company have a low payout ratio though or else it would need to cut its dividend in order to stay solvent.
Earnings Growth: Like all stocks, future earnings growth is ultimately what determines the stocks value.
The Growth Approach
Unlike value investors, growth investors are focused on fast growth – fast enough that the company can outgrow other concerns, like debt. Growth investors aren’t worried about finding cheap stocks whose stock price is discounted, they’re focused on the companies ability to rapidly increase earnings.
The growth approach is seen as a more risky strategy, since most stocks that fall into this category have a high price-to-earnings multiple, which makes them vulnerable to bear markets. Growth is critical – a company that hits a snag or slows down will see its stock price drop quickly. Unlike value stocks, growth stock have far fewer key metrics. The most common ones used in this type of investing strategy are simply the price-to-earnings ratio and earnings growth.
Price-to-Earnings: In a growth stock, this ratio tends to be high, reflecting investors belief that the company will eventually grow its earnings high enough and fast enough to justify the higher multiple being paid.
Earnings Growth: Earnings are everything for a growth stock. A high-estimated EPS growth rate is what drives the stock’s price higher. Companies that can accomplish this make all other ratios irrelevant, since they change radically in a short amount of time.
Whether you tend to investing in value stocks more than growth stocks or vice versa, it’s a good idea to keep a mixture of both in your portfolio. Both strategies have their strengths and weaknesses and neither is necessarily better than the other. The trick is to figure out which type of strategy you should use when valuing a potential stock investment. With practice, you’ll be able to quickly identify which strategy to use and take your portfolio to the next level.