Stocks are commonly classified into two main categories: value stocks and growth stocks. While this classification isn’t set in stone, there are distinct features that set each apart from the other.
Value stocks provide steady returns, while growth stocks come with the potential to multiply in value over time. What are the characteristics of each, what risks do they entail, and how should you decide which one to choose?
Let’s take a deeper look at what makes growth stocks different from value stocks, how they work, and how investors can make the best use of each.
Overview: value stocks vs growth stocks
|Undervalued, with low P/E Ratio
|Overvalued, with high P/E Ratio
|Tends to be more mature and well-established companies
|Tends to be younger companies with unique or disruptive products
|Expected to provide steady and modest returns over time
|Expected to deliver outsized returns relatively quickly
|Higher dividend payments
|Lower dividends payments (or none)
|Lower volatility in stock price
|Greater volatility in stock price
|Requires ability to avoid value traps
|Requires ability to pick winners early
What are value stocks?
Value stocks are stocks that are currently undervalued, i.e., the market believes their stock price does not fully reflect their earnings and long-term growth potential.
This can be a relatively unknown company with great prospects that the market hasn’t gained attention in the market yet, or well-known corporations facing temporary declines in stock prices due to internal factors like a company crisis, or external ones such as headwinds faced by the industry.
Value stocks tend to be of more mature, well-established companies, with proven business models and long-term revenue growth prospects.
Such companies tend to pay higher dividends – this is because their business is at a stage where steady revenue growth is the focus, and thus they can afford to distribute a higher percentage of their profits to shareholders.
Pros of value stock investing
Value stocks offer comparatively more stable stock prices due to their mature revenue model and more predictable earnings, without the wild swings that may be found with growth stocks.
Another benefit offered by value stocks is income generation, often resulting from higher dividends that they tend to pay. Many successful companies also have a track record of gradually increasing the dividends they distribute over time, contributing to consistent capital appreciation.
Furthermore, value stocks generally have a tendency to withstand challenging economic times better, attributed to several factors such as higher brand recognition, a more established customer base, lower debt, larger cash reserves, and more.
Cons of value stock investing
The flipside of having more stable stock prices is that the potential for greater-than-average returns is curtailed. As a result, value stocks may be perceived to offer slow or stagnant capital appreciation, especially in a shorter time frame.
Another downside is that value stocks may not appreciate as much as expected in stock prices, which might bore or frustrate investors looking for flashy price action.
Some value stocks also run the risk of being a value trap; this refers to a company with diminishing future prospects, making it challenging to achieve a favorable return on investment with such stocks.
Investors must avoid being too overly swayed by attractive valuations and instead, be vigilant in spotting potential value traps.
What are growth stocks?
Growth stocks are stocks that the market believes can deliver better-than-average returns. . Investors are willing to pay a premium for this potential, and thus driving the price up into overvalued territory, which is manifested in a higher P/E Ratio and other metrics.
Compared to value stocks, growth stocks tend to be of younger companies that aim to disrupt the industry with innovative or game-changing products and services. The corporate focus is to grow as quickly as possible into a market-leading position.
Accordingly, growth stock companies tend to favour reinvesting profits to further develop the business, rather than distribute them to shareholders.
Successful growth stocks are likely to see speedy advances in revenue, and later on, burgeoning profitability. The rise in these key metrics fosters increasingly positive views of the company’s value, which translates to higher share prices that can generate more business opportunities, creating a positive feedback loop.
Pros of growth stocks investing
Growth stocks are favoured for their greater potential to outperform the market. Dramatic spikes in stock prices and huge rallies that happen over relatively short periods are not unheard of among growth stocks.
Furthermore, growth stocks often offer the potential to disrupt the market or fundamentally alter established norms, and those that succeed have the capacity to yield substantial rewards for investors. In certain instances, they might even result in life-changing capital gains.
Cons of growth stocks investing
Growth stocks are inherently more volatile than value stocks, and require a higher risk tolerance. Stock prices can go through wild swings up and down, which needs the investors to have a strong stomach for risk and volatility.
Succeeding with growth stocks requires the ability to identify early winners, and the conviction to hold them through tough times as it may take a while for the stock price to truly take off.
Another drawback of investing in growth stocks is the lack of income generation. Due to the need to grow the business as quickly as possible, growth stocks tend not to offer lower dividends, or even none at all.
Finally, growth stocks can be more sensitive to economic headwinds, as they are likely to have higher debt levels, and need to rely on continued external funding.
Should you choose value stocks or growth stocks?
Certainly, there’s nothing inherently wrong with investing in both growth stocks and value stocks. Each of these categories has its own merits and drawbacks, and they can complement each other within a portfolio.
Also, in practice, many stocks have characteristics of both growth stocks and value stocks, so trying to focus exclusively on one or another may be moot.
Ultimately, which you should choose boils down to your investing aims, preferences and timeline.
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Benefit from both value stocks and growth stocks with Vantage share CFDs. You’ll even enjoy $0 commissions when you trade US share CFDs with Vantage. Sign up and experience the difference with Vantage today!