Value vs. Growth: Which Way of Evaluating a Stock’s Potential is Better?

Spend two minutes on any investing Website and you quickly realize that evaluating a stock is far more complicated than that “buy low/sell high” advice your uncle gave you.

Before you delve into all those charts, graphs, and spreadsheets, you need to decide what kind of investor you are. A number of philosophies and strategies guide how investors view the purchase of shares in a company. There are two prominent schools of thought most investors tend to abide by, however: growth and value.

Simply put, growth investors seek out stocks with above average growth potential, with little regard to the current share price. Value investors, on the other hand, look to buy stocks trading at a discount or well below what is believed to be the actual value of the shares. Though objective experts believe neither philosophy is better than the other, each school of thought has armies of staunch, single-minded supporters.

Value Investing

Value investors love a bargain. The philosophy is pretty easy: find stocks that are cheap, either because the company is experiencing temporary difficulty or because of a bear market, and buy. For this strategy, value devotees look at the “intrinsic value” of the stock — the actual value of the company — and compare it to the value investors have given its shares in the market. You can look at intrinsic value as the value of the business including its assets, earnings, and dividends. In other words, the total money to be paid for the company if someone was to buy it out completely.

So, how do value investors define a bargain? How low is “cheap,” and how high is “too expensive”?

“It’s a difficult thing to do but the best value investors are able to look very clearly when stocks are out of favor,” says Eric McKissack, CEO of Channing Capital Management.  That’s, in part, because value investors take a very technical approach to scouting out stocks.

“They are generally looking backwards, they’re almost like historians,” says Quintano Downes, CEO of Haven Financial Services . “Value investors examine financial statements of the company over the years.” They may also calculate a company’s “price earnings ratio” (p/e) to examine whether the current stock price of the company

is less than the value of the company. A price earnings ratio divides a company’s current share price by its earnings per share (EPS) — otherwise known as the profit the company makes per every outstanding share. Here’s a simple example: If a company is currently trading at $50 a share and earnings over the last 12 months were $2 per share, the P/E ratio for the stock would be 25 (or $50/$2).

Growth Investing

Unlike value investors, growth aficionados look for companies with the best prospects for above average growth. “Growth investors believe that by buying companies whose earning are growing faster than average that is the best way to get a return,” says McKissack. These investments may be in larger companies such as Google (GOOG) or Apple (AAPL).

“Growth investing has to do with name recognition,” says Douglas Coe, managing partner and chief investment strategist at Moody Reid Financial Advisors. “These are companies that everybody knows are making money. Their services are in demand and product is good and hot right now,” he adds. Unlike value investors, growth-lovers tend to

ignore higher p/e ratios. If a growth investor believes a company’s share price hasn’t yet hit its peak and still has potential for rapid growth, she will purchase shares, hoping to sell at a later date at a much higher price.

So, which is best?

While some investors like to choose sides in the growth-vs.-value debate, others employ a mix of the two philosophies. In any case, diversification is key. Incorporating both value and growth strategies helps reduce risk in your portfolio. Whether it be mutual funds, or a personal portfolio, depending on your investing goals, think about looking into a value/growth blend. And remember, “putting all your eggs in one basket is scary whether its growth or value,” says Jason Tyler, senior vice president at Ariel Investments. “Neither one is necessarily safer than the other.”