When you buy a stock, you're paying the quoted price for a claim against that company's future earnings stream. You've become a part-owner of the business, and any investor's hope is that his or her stake will generate returns that beat the growth of the broader stock market over the long term.

One of the ways Wall Street likes to classify stocks is to look at them as either growth stocks or value stocks. The truth is that most investments carry elements of both varieties. Yet there are important differences between the two categories.

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What is a growth stock?

A growth stock is typically one that prioritizes sales and profit gains over most other financial metrics. As such, it tends to have some mix of the following characteristics:

  • Above-average revenue and/or profit growth.
  • High valuation in terms of the price that investors are willing to pay as a multiple of annual profits. This metric is captured in the price-to-earnings ratio.
  • High valuation in terms of the price that investors are being asked to pay in terms of other metrics, such as book value, or the value of a company's assets, after subtracting its net debt. That valuation metric is typically tracked by the price-to-book ratio.

What's important to remember is that sales gains aren't intrinsically valuable but a means to an end. For example, many growth companies seek higher revenue so that they can achieve a certain scale. Size confers major financial advantages, including by spreading fixed costs out over a larger sales base. A market-share leader, meanwhile, tends to enjoy stronger pricing power than its rivals.

Therefore, market-beating sales or profit gains today tell investors two important things about the business. First, its products are in unusually high demand right now. And second, the company's influence is growing, which might translate into even higher profits in the future.

In part because of that focus on the future rather than the present, growth stocks are riskier to own. After all, investors are attempting to predict the long-term value of a quickly growing business, and so even minor changes to that expected expansion trajectory can send shares booming, or plummeting. Since most of the the stock's value is predicated on revenue and profits that have yet to materialize, there's not as high of a valuation floor as there would be for a mature company with a bigger but more stable sales base.

In addition to that volatility, growth stocks are riskier, because by their nature, they are less well established than their mature peers. That positioning confers some advantages, but it also leaves companies exposed to competitive threats, such as aggressive price-cutting and increased marketing spending from rivals.  

How can I find a growth stock?

Elevated valuation metrics are good clues that you've found a growth stock. But there are other ways to know as well.

Growth-stock companies stand out in sending relatively little cash to their shareholders, for one. A mature, slow-growing company will often pay dividends year after year, for example, while spending cash on stock repurchases. But a growth-focused management team is busy pouring all of its available resources into building up its sales base. Executives might even supplement those cash flows by taking on new debt, so that the company is investing more into the business than it's generating in terms of profit.

Most industries have a share of growth stocks, but the technology sector is the most heavily populated with growth-focused companies. On the other end of the spectrum is the utility industry, which mostly includes stable, slow-growing businesses that deliver lots of cash to shareholders in the form of dividends and stock repurchases.

Home Depot (NYSE:HD) is a classic growth stock right now. The home-improvement retailer increased sales by 7% in the past fiscal year, about double the pace of its closest rival, Lowe's (NYSE: LOW). Its gross and operating profit margins are also significantly higher than those of its peers. In exchange for that outperformance, investors are being asked to pay 26 times earnings for Home Depot, which is a premium to the broader market at 24 and Lowe's at 22.

Home Depot's premium is at least partially justified by its higher profitability, its quick and more consistent sales growth, and its leadership position in the industry. The retailer's management team has a stellar track record for capital allocation, too, which has helped Home Depot generate some of the highest returns on invested capital in the stock market. 

Its relatively high stock price means Home Depot has more room to decline if the business begins underperforming. Other key risks to owning these shares include the volatility associated with inevitable downturns in the housing market. But growth investors have done well to look past those concerns and focus instead on Home Depot's formidable competitive strengths, which should see the company through future industry contractions.

What is a value stock?

A value stock, on the other hand, is one that appears cheap based on any number of valuation metrics when stacked up against peers in its industry. It's characterized by the following factors:

  • Relatively steady and predictable sales and profit growth.
  • A below-average price-to-earnings ratio, or the multiple of annual profits that the stock price is worth.
  • A below-average price-to-book ratio, or the multiple of assets the stock price is worth.

In comparing these two lists, we find that growth stocks and value stocks represent two diametric investing styles. An investor could pay a higher price for faster growth or shell out a lower price for slower growth.

Because investors assign a lower premium to value stocks, there's less risk of dramatic price declines than with growth stocks. Value stocks have their own risks, though. 

In many cases, for example, a stock is valued at a deep discount to its rivals for good reasons. It could be stuck in a long-term market-share slump that promises to steadily whittle away at its earnings power. The company might also lack a strong competitive moat, and so its profitability is weak and under constant threat from rivals. This type of situation is called a "value trap," which means that rather than representing a temporarily depressed stock price, a discounted stock might simply remain discounted or even fall further over the long term.

How to find a value stock?

A stock screener is your best friend when hunting for a value stock. You can search for companies with price-to-earnings or price-to-book ratios below those of their industry peers. These stocks are likely to return a high proportion of earnings directly to shareholders in the form of dividends and stock repurchase spending. Thus, searching for unusually high dividend yields will also help produce a list of candidates. 

A value stock's share price is likely to have barely kept up with the broader market over the intermediate term, in a reflection of the low expectations Wall Street has placed on the business. That's why many value investors like to scan the list of equities that have hit 52-week lows for stock-buying ideas.

Value stocks tend to be overrepresented in low-growth or declining industries that, for whatever reason, have fallen out of favor on Wall Street. Think regional water utilities rather than microchip specialists, or a stodgy telecommunications giant over a surging software specialist.

J.M. Smucker (NYSE:SJM) fits the characteristics of a value stock today. Investors are being asked to pay just 9 times earnings for shares of the consumer packaged-foods giant, in part because its industry is under intense sales and profitability pressures. The company missed recent earnings targets and is expecting flat sales over the next year. It's struggling to keep its prices steady even as costs rise for many of its core food inputs. As a result, gross margin is dropping.

Executives are hoping a combination of innovative product releases and an aggressive portfolio realignment will eventually return the company to a sustainably strong growth pace. Smucker has a powerful collection of hit food brands that should help. Still, the company has yet to show concrete evidence of a turnaround, and so Wall Street's fears about continued struggles appear justified today. 

Why do growth stocks have high P/E ratios?

There's an important psychological component here that's represented by the valuation gap between the two categories. A growth stock, by virtue of its high P/E ratio, is trading at a premium that reflects Wall Street optimism about its future. Investors are paying more for the stock because they believe it will continue to grow at above-average rates.

In many cases, they're betting that what looks like a high price-to-earnings multiple today will appear to be a bargain in the future, after the company has slowed its rate of reinvesting into the business and instead allows profit margins to expand. This situation often occurs as younger companies establish themselves in an industry, directing all available profits toward that goal for a time, before increasing earnings as they mature.

A value stock, meanwhile, has fallen out of favor for some reason, and so Wall Street has become pessimistic about the business. That pessimism is best reflected by a low earnings multiple relative to its peers or to the broader stock market.

As the U.S. Securities and Exchange Commission explains to beginner investors, "people buy value stocks in the hope that the market has overreacted and that the stock's price will rebound while growth stocks attract investors in the hope of capital appreciation."

Famous growth and value investors

Billionaire investor Warren Buffett has typically been associated with the value side of this debate. He famously resisted buying technology companies during the rally in the late 1990s, for example. Buffett avoided these stocks mainly because he didn't have as deep an understanding of their businesses as he did with consumer-focused companies that made products such as soda, candy, and razors. He calls his approach staying within your circle of competence.

Yet there was a major valuation component to his bet against tech stocks, too. Citing Wall Street's "rosy expectations" in 1999, Buffett said these stocks couldn't live up to their high prices. "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow," he argued in late 1999, "but rather determining the competitive advantage of any given company and, above all, the durability of that advantage."

Philip Fisher was another highly successful investor, and his 15-point stock screening profile, laid out in his book Common Stocks and Uncommon Profits, describes a few fundamental aspects of the growth approach to investing. Fisher looked for companies with the potential for a "sizable increase in sales," and stocks that were maintaining or improving their profit margin. "The greatest investment reward," he wrote, "comes to those who ... find the occasional company that over the years can grow in sales and profits far more than industry as a whole.."

Which approach has performed better?

Statistical studies, including a 26-year analysis from Fidelity, suggest that value stocks might have a slight edge in the debate over which class of investing works better for investors. Between 1990 and 2015, Fidelity found, funds that focused on value stocks modestly outperformed their growth-focused peers.

The conclusion isn't so straightforward, though. After all, this analysis showed that growth stocks tended to outperform value stocks during bull markets, such as in 2013, while underperforming during downturns such as the one in 2009. That's why value stocks have a reputation for being more defensive, meaning that they hold up relatively well through recessions. But it isn't possible to know ahead of time what kind of market you'll be investing through, and so it makes sense to hold a mix of both types of stocks.

Aim for a mix in your portfolio

While there's room for growth and value stocks in any investor's portfolio, the real danger comes in rigidly applying these rules. Limiting your stock search screens only to companies with low valuations will exclude many strong businesses that, while seemingly expensive, tend to outperform their peers over long periods.

It's important to consider your personal risk tolerance, investment style, and time horizon. Generally, the more time you have to allow your investing thesis to play out, the more cash you can allocate toward volatile stocks that have yet to settle into mature growth periods.

On the other hand, it's just as risky to blindly purchase the most popular, fastest-growing stocks without taking into account other important characteristics, such as brand power, market potential, the leadership team, and profitability. Jumping into an investing craze, whether it involves cryptocurrencies, cannabis, or the next idea to grip Wall Street, is a sure way to tilt the odds of success against you. After all, what's a good investment at one price can easily be a poor investment at a much higher price.

But whether you're buying a value stock or a growth stock, your returns ultimately depend on a few key factors, including the quality of the underlying business and the price you paid to purchase your tiny piece of that operation. Ignoring either of these growth and value elements sets you up for disappointing long-term returns. On the other hand, buying quality businesses at reasonable prices, and holding them over years and perhaps decades, is a great way to slowly build wealth as an investor.

Demitrios Kalogeropoulos owns shares of Home Depot. The Motley Fool has the following options: short September 2018 $180 calls on Home Depot and long January 2020 $110 calls on Home Depot. The Motley Fool recommends Home Depot. The Motley Fool has a disclosure policy.