Value vs. Growth Investing: What's the Difference?

Investing is the best way to save for retirement or pay for your child’s education, but it requires careful thinking and strategizing if you want to earn the returns you need. While there are many approaches to consider, one of the most important decisions you will make is choosing value vs. growth investing. Each has its benefits and risks.

At Addition Financial, we always want our valued members to have the information they need to make their financial goals into realities. That includes understanding investment strategies and what they mean for our membership's future. With that in mind, here’s our guide to the value vs. growth investment styles, with definitions and examples of each.

What is a Growth Stock and How Does It Work?

Growth stocks are stocks that are expected to grow at a rate that outstrips the market, delivering higher-than-average total returns to investors. In many cases, growth stocks are small-cap stocks, which means they have market capitalization between $300,000 and $2 billion. They may be companies that have just begun trading publicly or alternatively, small companies that have been around for a while but have exhibited significant growth potential.

Key Characteristics of Growth Stock

There are some characteristics that growth stocks have in common with one another. If you’re considering a growth investment strategy, then look for these things:

Historical earnings. The company should be on a growth trajectory, even if growth has not been exponential since the company’s inception.
Return on equity. How efficiently is the company turning income into profits? You can calculate ROE by dividing the net profit by the total shareholder equity in the company.
Projected earnings. How much does the company expect to earn going forward? For example, a tech company with an upcoming product launch might expect to see a significant spike in earnings as a result.
Competitive advantage. A company’s stock is most likely to increase in value when there is a distinct advantage over competitors due to the company’s unique products or processes.

It’s important to keep in mind that another characteristic of growth stock is that investing in it carries some risk above and beyond what you would see with other types of investments.

What Are Examples of Growth Investing?

Growth investments may come in several forms. Here are some of the most common types of growth investments:

Small-cap stocks. As we noted above, small-cap stocks are the most likely to experience rapid growth as compared to mid-cap or large-cap stocks.
Growth dividend stock. Investing in growing companies that pay dividends can help you to offset some of the expense of buying stock and provide some mitigation for the risk involved in growth investing. (We should note here that dividends are more common with value stock than they are with growth stock.)
Healthcare & technology stock. Companies in the technology and healthcare sectors often have significant growth potential thanks to their ability to disrupt the market with new products.
Speculative investments. Speculative investments may be growth investments, but they carry a high level of risk that makes them unsuitable for people who can’t afford to lose their entire investment. Examples include penny stocks, foreign currencies, futures and speculative real estate investments (undeveloped land.)

If you do decide to try a growth investment strategy, we recommend avoiding speculative investments and balancing your portfolio with some lower risk investments to protect yourself.

What is a Value Stock and How Does It Work?

A value stock is a stock that may be undervalued in the market, meaning that it is trading at a price that investors feel is too low based on the company’s historic performance and earnings. As a rule, value stocks tend to be from companies that are large and well-established. They often pay dividends and are more likely to do so than smaller companies.

Key Characteristics of Value Stock

Here are some of the characteristics to look for when evaluating stocks to see if they are value investments:

Price to book value ratio. Often referred to as the P/B ratio, this measurement compares the market value of a share to the book value. A ratio of under 1.0 indicates a value investment.
Price to earnings ratio. Also known as the P/E ratio, this calculation takes the market value of a stock and divides it by the earnings per share. It indicates whether a stock is overvalued or undervalued, with undervalued stocks being the best value investments.
Dividend discount method. Another way to determine the nature of an investment is to calculate the sum of all future dividends and discount them back to their current value. If the present-day stock price is equal to or less than the total, then it can be part of a value investment strategy.
Maturity. In most cases, value stocks are issued by companies with a long and stable history.

As you can see, the key is using a variety of metrics to give you an idea of how much value you can expect to see from your investment.

Examples of Value Investments

The P/E ratio is one of the easiest ways to identify value investments. Here are two examples as of April 2023:

Citigroup has a P/E ratio of 9.67 compared to the average P/E ratio for S&P 500 companies, which is at $19.12.
iShares S&P Value ETF is an exchange-traded fund that allows investors to put their money into an array of value stocks.

The benefit of investing in value stocks is that you are likely to earn a return on your investment as the stock you buy increases to its book value.

What Are the Key Differences Between Growth Stocks and Value Stocks?

Now, let’s look at a few of the most important differences between growth investing and value investing.

Risk

The first and arguably the most important difference between growth investing and value investing is the risk involved. Value stocks tend to be from large, well-established companies that are outperforming their market value. While there is still some risk involved in buying value stocks, it is small compared to the risk in growth investments.

Growth investments are based on a company’s future potential and not on its history. These companies may experience exponential growth, but there is also a high risk of failure. Even if you do extensive research, there’s still a risk that you may lose some (or all) of your investment.

Potential Earnings

Both value stock and growth stock have the potential to earn money for investors. The difference is that value stocks provide the opportunity for slow and steady growth. Because they are typically undervalued in the market, there’s a strong likelihood that your investment will gain value as the market price catches up to the book value.

By contrast, growth investments have the potential to experience tremendous growth, particularly if the company in question launches a new product that disrupts the stock market and changes things for the better. On the flip side, there’s also the possibility that you’ll earn less with a growth investment if the company underperforms and never realizes its potential.

Dividends

If you’re interested in turning your investments into monthly income, your best option is to choose dividend stocks. Most companies that pay dividends do so on a quarterly basis and the income can offset the cost of buying the stock, but it may also lead to slower overall growth.

As we noted above, value stocks are more likely to pay dividends than growth stocks, although growth stocks sometimes do. You can use the dividend discount method we described above to evaluate the earning potential of a dividend stock.

Value vs Growth Investing: Which One is Right for You?

Here are some things to consider before you choose an investment strategy:

Your tolerance for risk. Risk tolerance is an important component of any investment strategy. If you’re comfortable with a significant amount of risk, then you may also be comfortable with a growth investment strategy, while if your tolerance is low, you may prefer value investments.
Your long-term needs. As a rule, people who invest when they’re young can afford to take risks because they’ll have time to recoup any losses they sustain. If you’re close to retirement age, then a low-risk strategy may be your best bet.
Diversification of your portfolio. Although we’ve talked separately about growth and value investing, nobody should view these options as all-or-nothing scenarios. You’ll have the best results if you invest in a mix of the two, with your value investments providing stability while your growth investments provide earning potential.

If you’re unsure about which investment strategy will deliver the results you want, you may want to work with a financial professional to discuss your options.

Build Your Portfolio with Value and Growth Investments

Both value investments and growth investments have their benefits, and the best investment strategy is to balance the two to deliver a combination of stability and potential earnings. You can see the metrics and methods we’ve discussed here to evaluate your investments before you buy.

Do you need assistance evaluating potential investments and building your portfolio? Addition Financial is here to help! Click here to learn about our Financial Services and schedule an appointment with a financial professional today.