Dividing stocks between "growth" and "value" is accepted practice in the investment world. After all, these categories are backed by a large body of academic work, so we can safely assume that they serve investors' best interests, right?

Wrong! I believe that much of that effort is wasted (for investors, that is -- it's profitable for the industry). In fact, it's largely counterproductive to the goal of achieving superior investment returns.

Growth vs. value -- a false debate
Growth stocks are generally thought to be characterized by high earnings growth rates and high price-to-earnings (P/E) or price-to-book value (P/B) multiples; value stocks are characterized by low growth and low multiples. However, stocks get forced into these buckets based on narrow criteria. The result is two lists, neither of which is particularly consistent or informative in terms of investment merits.

Where's the evidence for that? Look no further than a recent article, "The Truth About Growth and Value Stocks" (registration required), published by McKinsey, a strategy consulting firm. In the article, the authors found that:

  • Collectively, growth and value stocks have similar revenue growth rates!

How could that be? We're accustomed to associating growth stocks with booming companies operating in high-growth industries, while value stocks bring to mind stodgy companies in old-line, slow-growth sectors. The observation is partially explained by a second finding:

  • Growth stocks are valued at higher P/B ratios and have significantly higher return on invested capital (ROIC) than value stocks (median ROIC: 35% for growth stocks vs. 15% for value stocks).

In fact, a "growth" stock that is priced at a high P/E or P/B can end up having

  • High growth, high ROIC
  • High growth, moderate ROIC
  • Low growth, high ROIC

Here are some examples of each of these possibilities:

High P/E ("growth") stocks

Company

Forward
P/E

Estimated 5-Year
Annual Earnings Growth

Return on
Capital

High growth, high ROIC

Amazon.com (NASDAQ:AMZN)

51.3

23.4%

22.7%

High growth, moderate ROIC

Monster Worldwide (NASDAQ:MNST)

18.7

23.8%

13.1%

Low growth, high ROIC

Coca-Cola (NYSE:KO)

18.5

9.1%

17.8%

Source: Standard & Poor's Capital IQ.

Stocks trading at low P/E or P/B multiples can come in many flavors, too:

Low P/E ("value") stocks

Company

Forward
P/E

Estimated 5-Year
Annual Earnings Growth

Return on
Capital

High growth, low ROIC

Sierra Pacific Resources (NYSE:SRP)

14.8

13.3%

3.8%

Low growth, moderate ROIC

US Airways (NYSE:LCC)

5.8

6.0%

9.0%

Low growth, low ROIC

TECO Energy (NYSE:TE)

14.2

3.3%

5.1%

Source: Standard & Poor's Capital IQ.

Understanding value and becoming a better investor
Growth and return on capital are two of the critical determinants of investment value. Drilling down within the "growth" and "value" categories, it becomes clear that the picture is more complex than our two initial labels suggest. This is all the more true because there's an interplay between growth and return on capital (for example, high growth actually contributes to value destruction if a company fails to earn its cost of capital).

If the traditional distinction between growth and value stocks is of no help in finding promising investments, where should you turn? At our Motley Fool Inside Value investing service, we're committed value investors, and we adhere to the holistic approach to value that Warren Buffett articulated in his 1992 chairman's letter:

"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase -- irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value."

The only way to determine the value of a stock is by estimating the intrinsic value of the underlying business. That value is the sum of the discounted free cash flows the business is expected to generate.

The Foolish bottom line
The key to investing successfully is digging deeply to understand the drivers that create business value and to estimate that value based on future free cash flows. Those are the hallmarks of our approach at Inside Value, where we refuse to rely on simplistic labels or a cursory analysis of price ratios to find stocks that are undervalued.

If you'd like to see the stocks we're recommending today or want to learn more about our business-focused approach to investing, click here to join our service free for 30 days. There's no obligation to subscribe.

This article was originally published on Feb. 22, 2007. It has been updated.

Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Amazon.com is a Motley Fool Stock Advisor recommendation. Coca-Cola is an Inside Value pick. The Fool has a disclosure policy.