What Value Stocks Look Like

Value stocks are often mature companies in industries such as banking, energy, and consumer staples. Many pay dividends, which are regular cash payments a company gives shareholders out of its profits.

Because they’re often established businesses with stable earnings, value stocks may hold up better during market volatility. The tradeoff is that they may lag growth stocks during periods of market highs.

Investors hunting for bargains see a stock as a value if the business is strong but the market hasn’t caught on yet that it’s a good deal. If they buy it now and wait, the hope is that the market will catch up.

A real risk to look out for is a value trap, which is a stock that is cheap, but it’s because the business has genuine problems.

What Growth Stocks Look Like

Growth stocks usually come from the technology sector, especially in areas where revenue is expanding quickly.

They rarely pay high dividends, because companies generally reinvest their profits back into hiring, research, and expansion instead.

When growth delivers, the gains can be big. The tradeoff is that investors tend to have high expectations for the stock, so a single piece of bad news can disappoint and send shares down sharply.

How the Two Styles Play Out

A simple way to differentiate between value and growth stocks is the price-to-earnings ratio, or P/E, which is a stock's price divided by the profit the company earned per share over the past year.

A low P/E means you pay less for each dollar of earnings, while a high P/E means investors are paying more because they expect profits to grow. Value stocks tend to have lower P/Es than growth stocks. 

Imagine two companies that each earn $5 in earnings per share this year. The first is a long-established insurance company whose stock trades at $60. It has a P/E of 12, so you pay $12 for every $1 of current earnings.

The second is a fast-growing artificial intelligence company whose stock trades at $200. It has a P/E of 40, so you pay $40 for every $1 of current profit.

Investors in the insurance company are betting the market is too pessimistic, and that a steady business priced at 12 times earnings will be worth more once the rest of the market notices.

Investors in the AI company are betting profits will rise fast enough to justify the higher price. If earnings grow 25% a year, they’ll reach about $15 per share in five years. If the stock price grows 15% a year over the same period, it will reach about $402, putting the stock’s P/E at roughly 26.

Performance: Value vs Growth

Over the long run, data shows that value stocks have outperformed growth stocks. On average, value has beaten growth by 4.0% annually in the U.S. since 1927, according to Dimensional Fund Advisors.

It’s important to note that this is a long-term average. Value stocks came out ahead in only 58 of 97 calendar years, and growth led for most of the 2010s. Past performance does not guarantee future results, and one strategy can lag the other for many years in a row.

Do You Have to Pick One?

It’s easy to frame value vs. growth as an either/or, but many investors choose a mix of each strategy. 

Your timeline is a big factor. Value investing may be better for older or more conservative investors who want to avoid market swings because they’re getting closer to retirement or have a lower tolerance for risk.

Growth's volatility may be easier to wait out if you’re a younger investor who can ride through market swings for a potential payoff.

You can also choose both. Having some growth stocks in your portfolio can take advantage of market upturns, while a balance of value can provide some stability.

Either strategy comes with risks, so it’s essential to research every investment thoroughly.