You might have heard the phrases “Value Stock” and “Growth Stock” thrown around by media outlets, but what differentiates a value stock from a growth stock? What makes value stocks appealing to some, and growth stocks appealing to others? In this blog post, we will go over these differences.
Value Stock
According to Investopedia, a value stock is a stock that tends to trade at a lower price relative to its fundamentals. Common characteristics of value stocks include high dividend yield, low price to book ratio, or a low price to earnings ratio. As the name suggests, value investors invest in value stocks. Ben Graham, the father of value investing, suggested that for a stock to be attractive and provide a margin of safety, it needs to have a high earnings yield. Earnings yield is simply the inverse of the price to earnings ratio. To better understand value stocks, let’s look at a real life example:
Walt Disney Co (DIS)
Disney’s Dividend Yield: 1.5%
Industry Average Dividend Yield: 0.9%
Disney’s Price to Book Ratio: 3.4
Industry Average Price to Book Ratio: 4.8
Disney’s Price to Earnings Ratio: 13.4
Industry Average Price to Earnings Ratio: 21.8
Disney’s Earnings Yield: 7.46%
Industry Average Earnings Yield: 4.58%
10 Year US Treasury Note Rate: approximately 3% (Nov 2018)
A value investor would look at these numbers and find Disney to be a value stock. In comparison to the industry average, Disney has a higher dividend yield, lower price to book ratio, lower price to earnings, and a higher earnings yield. When compared to the 10 year treasury note, Disney has a built in 4.48% (7.46% – 3% = 4.48%) margin of safety, which is greater than that of the industry average. Investing in value stocks is considered to be less riskier than investing in growth stocks. Why do I say that? Well, let’s look into growth stocks first.
Growth Stock
According to Investopedia, a growth stock is a stock that is anticipated to grow at a rate significantly above the average for the market; growth stocks usually do not pay dividends, since the company wants to reinvest its earnings in order to accelerate its growth in the short run. For a value investor, margin of safety is an important concept, which is always dependent on the price paid. Since the market has a tendency to set prices for such favored (growth) stocks at a higher rate, the margin of safety is minimized. This is what makes growth stocks riskier. As the security gets riskier, there will be frequent fluctuations in the stock price. This implies that the price to earnings ratio of such stocks is going to be high. To better understand growth stocks, let’s look at another real life example:
Amazon.com Inc (AMZN)
Amazon’s Dividend Yield: 0.0% (Amazon does not pay dividend)
S&P 500 Dividend Yield: 2.0%
Amazon’s Price to Book Ratio: 20.4
S&P 500 Price to Book Ratio: 3.1
Amazon’s Price to Earnings Ratio: 91.2
S&P 500 Price to Earnings Ratio: 18.8
Amazon’s Earnings Yield: 1.09%
S&P 500 Earnings Yield: 5.32%
10 Year US Treasury Note Rate: approximately 3% (Nov 2018)
As a growth stock, Amazon does not pay any dividends. Since the market favors this stock, the price of Amazon is extremely high in comparison to the S&P 500 Market average; The price of Amazon is 91.2 times its earnings. The price to earnings ratio and the earnings yield show that Amazon is an overpriced risky stock. A zero risk 10 year US Treasury note guarantees a return of 3%, whereas Amazon’s earnings yield is only 1.09%. A value investor would not invest in Amazon because it is lacking the margin of safety. On the other hand, a growth investor would like Amazon because the stock is favored by the market and has the potential to earn greater earnings in the future.
Hope you learned a little and found this blog post helpful. We talked about the difference between value and growth stocks. We also went over the numbers that value investors and growth investors look for. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you! Note: The numbers above were taken from Morningstar.
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