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  • Writer's pictureRohan Bhatia

Growth Stock vs Value Stock

Growing up, I always had a very clear image of what a stockbroker or investment banker should look like. A middle-aged man, probably with glasses, sitting in front of an excel spreadsheet. In all likelihood, they were throwing in numbers to see what the spreadsheet would spit out. In short, I had always imagined these guys to be value investors.


The reality is, in 2020, that value investing has thoroughly underperformed its counterpart: growth investing. But what is the difference between a growth stock and a value stock? Are both plausible in the biggest bull run in history as we move into 2021?


Value investing: The more traditional approach


As I thought as a teenager, the more traditional approach as an investor has been in value. Simply, this just means looking for companies significantly undervalued from their 'intrinsic' value, and buying them with the expectation they should eventually return to their actual value. Naturally, the question that comes to everyone's mind is - how on earth do I value a company?


Value investors have been pretty much undecided on the best way to value a stock.


The most common way is the Discounted Cash Flow (DCF) method, which takes all of the expected incoming cash flows of the business - usually in the form of earnings/profit - and discounts them back with a nominated discount rate. This discount rate is generally the return that the investor expects to receive, at the very minimum, from the stock.


Another method, slightly less popular among value investors, is the Discounted Dividend Model (DDM). This, of course, will only work for stocks currently paying a dividend, which is just a small cut of a company's profits they pay to shareholders. Treating the stock as a growing perpetuity, you can use expected growth in the dividend payment and the relevant discount rate to arrive at a value for the stock.


As a value investor, P/E ratios, earnings growth, and return on equity are all useful metrics to measure the viability of a stock.


The most successful and iconic investor of all time, Warren Buffet, is a living example that value investing is a clear road to successfully beating the market. Modern-day value investors all but model their philosophy on the back of Buffet's approach, which is to find the best quality companies, with a lot of future potential, and at a heavily discounted price. For example, in 1988, Buffet bought a substantial stake in Coca-Cola - swayed by high-profit margins, huge global reach, and an unforgettable brand. Luckily for him - the stock was also at an incredibly undervalued price too. It's a stock he's held since then and he delivered him with billions of dollars in returns.


This all sounds great. So then why do most 21st century investors sway toward the growth strategy?


Growth investing: More risk, more return


If you asked a value investor what they think about Tesla, they'd likely laugh in your face. Despite all of that though, Tesla stock's massive run-up in share price over the last year is a testament to how out of touch value investors can often be.


What these value investors are missing, however, is where these growth stocks are in the cycle of business progression. Firstly, it is all but impossible to truly value a company that still hasn't turned a profit. This is significant because it often takes businesses up to 8-10 years to actually generate a profit. This is because equity and debt are used to fund expansions, acquisitions, and other growth projects. In fact, Tesla only turned its first annual profit this year.


Usually, a value investor will maintain that a company's P/E ratio - that is its price divided by earnings per share - should sit around the 15-25 range. Anything above this and you're likely dealing with a stock that is trading at a higher price than its earnings should warrant. Tesla, which has been the trending growth stock of 2020, has a P/E ratio of approximately 1650 - seen as absurdly high by all value investors.


Growth investors warrant this by pricing in future earning capabilities. Given that Tesla deals in the Electric Vehicle space, has an eccentric CEO in Elon Musk, and continues to be involved in pop culture - investors are extremely confident about the company's future potential.


Value investors also would've missed out on stocks like Apple, Microsoft, Amazon, and Facebook due to lofty valuations and extremely high P/E ratios.


The growth investing philosophy focuses on trends in business, trends in consumption, and the general trajectory of the world. This is why, for the most part, almost all large growth stocks are involved in the technology sector - because that is where society is naturally leaning.


Conclusion


Ultimately, both value investing and growth investing have their place in the world of stock market investing. Whilst a value investing approach is likely less risky, the capacity for earning 1,000% or more on an investment is much more likely when investing into a growth stock in its formative years.

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