Growth vs value investing

Growth and value are the two best-known investing styles. Growth investors favor companies whose sales and profits are expanding quickly and accept high prices for them. Value investors favor companies priced low relative to what they earn or own, and accept slower growth. The labels are useful shorthand, but they describe tendencies more than two opposing camps.

What each style looks for

Style index providers draw the line using rules based on measures such as price-to-book, earnings growth and sales growth, so the same company can be classed differently by different providers. Index series for large companies typically divide the universe into growth and value portions, and some stocks can sit partly in both.

Same math, different emphasis

In a discounted cash flow view, a company's value is the present value of its future cash flows. Growth is one of the inputs to value, not an alternative to it. A growth stock is cheap if its future cash flows exceed what the price implies, and a value stock is a bargain only if its cash flows hold up. The simple P/E formula shows the link:

P/E = Payout ratio x (1 + g) / (r - g)

Higher growth (g) raises the justified multiple, and a higher required return (r) lowers it. So a high multiple is not by itself a sign of overvaluation, and a low one is not by itself a sign of a bargain. The PEG ratio is one attempt to put price and growth into a single number, a useful shorthand that has to be treated with care.

Example (illustrative numbers)

Company A trades at 12 times earnings with earnings growing about 3% a year. Company B trades at 35 times earnings with earnings growing about 20% a year. Which is cheaper?

If earnings really compound at those rates, B's earnings per share after ten years would be about 6.2 times today's (1.20 to the tenth power), against about 1.3 times for A (1.03 to the tenth power). If B's multiple fell from 35 to 20 over that decade, its price would still rise about 3.5 times (6.2 x 20 / 35), while A at a steady multiple of 12 would rise about 1.3 times. But that outcome depends on 20% growth lasting ten years, which few companies manage. If B grew only 8% a year (earnings about 2.2 times in ten years) and its multiple fell to 15, the price would end up roughly 7% lower even though earnings more than doubled. A, on the other hand, is a bargain only if its earnings stay stable and do not decline.

The example shows the central tension: growth investors depend on duration of growth, value investors on the quality of what they buy at a discount.

What the research says, and what it does not

Academic work, most famously by Eugene Fama and Kenneth French in the early 1990s, found that over long periods lower-priced stocks (measured by book value to price) earned higher average returns than higher-priced ones, known as the value premium. Explanations differ: compensation for risk, behavioral overreaction to bad news, or a mix. The premium has not been steady. There have been long stretches, sometimes lasting many years, when growth stocks led, and others when value did. Past style performance does not tell you which will lead next, and any claim that one style always wins should be treated skeptically.

How to read it

Rules of thumb:

• Judge a style by the quality of the individual business, not the label. There are bad growth stocks and good value stocks.
• Ask what growth rate the price requires. A reverse DCF turns a high multiple into an explicit expectation you can test.
• Check that cheapness is not a symptom. Falling sales, rising debt or heavy dilution can explain a low multiple.
• Many investors blend the two, looking for reasonable growth at a reasonable price, often combined with quality screens.

Common mistakes and limits

• Equating cheap with value. A low P/E alone is not enough, since value requires a gap between price and worth.
• Equating growth with quality. Growth that requires heavy investment for low returns may add little.
• Style chasing. Switching to whichever style has done best recently often means buying after the move.
• Ignoring size and sector. Style labels can hide sector concentration, and value indexes have often leaned toward sectors such as financials and energy while growth indexes have leaned toward technology.
• Forgetting the margin of safety. For either style, paying less than the estimated worth gives protection against being wrong. See margin of safety.

Where to see it on StocksXray

The X-Ray Score has both a valuation lens (25%) and a growth lens (20%), so a stock that ranks well on both is the type that blends the two styles. You can browse stocks labeled Undervalued, then check each company's fundamentals to see whether the discount comes with growth or with decline.

Key takeaways

• Growth investing pays up for expansion, while value investing seeks prices low relative to fundamentals.
• Growth is an input to value, so the styles share the same underlying math.
• Style leadership rotates over long stretches, and neither style wins every period.
• Judge the business and the price it requires, not the label.