Investors often throw around the terms "growth" and "value" when referring to stocks, but do you know what those terms really mean and how to choose which type of stock is best for you? Worry not, because you're about to find out.
What is a growth stock?
A growth stock is, unsurprisingly, the stock of a company focused on growth. These companies are typically young, and their goal is to expand and grab market share, so rather than using their cash to pay out dividends or repurchase their shares, they plow it back into the company, often by investing in equipment, new facilities, research and development, and so on. Growth stocks typically have above-average P/E ratios; the rationale is that because the company is growing so quickly, their potential future profits justify their high valuation. Note that the long-term average P/E is about 15, but this can vary widely based on industry and current market conditions; as of this writing, the average P/E ratio for the S&P 500 is almost 26 .
Amazon is the perfect example of a growth stock that did its shareholders proud. When it first debuted on the stock market in the late '90s, investors paid a pretty penny just for the potential of future earnings. The company didn't turn a profit for years, and it's still reinvesting so much into its business that even now, profits are far from a given. And yet in its 20 years on the market, Amazon stock has grown to 500 times its IPO value.
What is a value stock?
A value stock is the stock of a company that an investor believes is undervalued. In other words, the price of that stock is lower than it should be based on the company's worth. Value stocks are more likely than growth stocks to pay dividends. They have below-average P/E ratios, which are one of the signatures of a value stock. Benjamin Graham, the father of value investing, recommended choosing stocks with P/E ratios of nine or below. When P/E ratios are inflated across the market, as they are today, you might go a little higher -- but it's wise to stick to companies with P/Es below 15 so that they will continue to be a good value when compared to the long-term market average. IBM is one classic example of a value stock; as of this writing, it sports a P/E of 12.46 and is a solid, well-established company with generous dividends.
Pros and cons of growth stocks
Because growth stocks belong to companies that are focused on using their funds to expand, they are often the stock of choice for investors seeking outsize capital gains. However, because growth stocks usually belong to newer, smaller companies, they are inherently riskier than your average stock. Investing in such a young, less established company is a gamble; if it's a success, you could make a fortune, but there's always a possibility that the company will go under, taking your investment with it.
Even if the company doesn't actually fail, you can still lose money if it turns out that a growth stock's high P/E ratio really is overblown and the company's growth fails to live up to the market's expectations.
Pros and cons of value stocks
If growth stocks are the hare in the stock market race, value stocks are the tortoise. They're not as exciting, but if you can find a stock belonging to a good company that's temporarily undervalued by the market, you can enjoy years of steady returns. Of course, if it turns out that you're wrong about the "undervalued" bit, then you could end up with a stock that just sits there for years on end or even drops in value.
he good news is that value stocks tend to belong to companies that are solid and well-established, meaning the risk that the company will fail entirely is low. And because these stocks usually pay respectable dividends, you'll be getting something back even if the capital gains are less than stellar.
Which should you choose?
Growth stocks are frequently riskier than value stocks, but they have the potential for faster, greater returns. Prudent investors will often choose a mix of growth and value stocks to help diversify their portfolio. On the other hand, if you have a specific goal in mind, you may choose either growth or value stocks to better meet that goal. For example, value stocks also tend to be high dividend payers, so if you're looking to build a portfolio for income, you'd want to have more value stocks in it. Meanwhile, if you're a younger investor who's saving for retirement, then you likely want to grow your wealth as fast as possible, and you also have time to ride out the inherent volatility of growth stocks.
Whichever investing strategy you choose, you can simplify it by choosing mutual funds or ETFs that follow either a growth or value approach; many such funds exist, and you can identify them easily by looking for the word "growth" or "value" in the fund's name. And if you choose index funds for this role, you'll save on fees, too.