Investors often divide stocks into two broad categories: growth stocks and value stocks. The distinction is based largely on how investors view a company’s future prospects and how much they are willing to pay for its shares.
Growth stocks are generally associated with companies expected to increase their earnings or revenue faster than the broader market. Value stocks, on the other hand, are generally companies whose shares appear inexpensive relative to their financial fundamentals or compared with what investors believe the business is worth.
The difference between the two can help explain why certain stocks perform differently during various stages of the economic and market cycle.
What Are Growth Stocks?
Growth stocks are shares of companies that investors expect to expand relatively quickly.
These companies may operate in industries with significant opportunities for expansion, such as technology, healthcare, communications, or emerging consumer markets.
A growth company might be reinvesting most of its profits into research, new products, hiring, infrastructure, or geographic expansion rather than distributing large amounts of cash to shareholders.
Investors purchase these stocks largely because they expect the company’s future earnings and cash flows to become significantly larger.
Why Growth Stocks Can Have High Valuations
Investors are often willing to pay a higher price for a growth stock because they expect strong future performance.
Imagine two companies currently generating similar profits. One is expected to grow much faster over the next decade.
Investors may be willing to pay more for each dollar of that company’s current earnings because they believe future earnings will be substantially higher.
This can result in growth companies having relatively high valuation ratios, such as price-to-earnings or price-to-sales ratios.
A high valuation does not necessarily mean a stock is overpriced. However, it does mean investors may have high expectations that the company needs to meet.
What Are Value Stocks?
Value stocks are generally shares of companies that appear inexpensive relative to measures such as earnings, book value, cash flow, or other financial fundamentals.
A value investor may believe that the market is underestimating the company’s true worth.
For example, a company could have established operations, valuable assets, and consistent earnings while its stock trades at a relatively low valuation.
The investor’s thesis is that the market has become too pessimistic and that the company’s share price could eventually rise as its underlying value becomes more widely recognized.
Why Do Value Stocks Become Cheap?
There can be many reasons.
A company may be operating in an unpopular industry, experiencing temporary financial difficulties, facing regulatory uncertainty, or dealing with a decline in investor confidence.
Sometimes the market’s negative expectations are justified. A company that appears cheap may continue to deteriorate.
This creates an important distinction between a value opportunity and a value trap.
A value trap occurs when a stock appears inexpensive but remains cheap because the company’s underlying business is actually deteriorating.
Growth Stocks and Interest Rates
Growth stocks can be particularly sensitive to changes in interest rates.
One reason is that much of their expected value may depend on profits and cash flows that are expected to occur years in the future.
When interest rates rise, those future cash flows are generally discounted at a higher rate when investors value the company.
This can reduce the present value investors assign to future growth.
Higher interest rates can therefore place pressure on highly valued growth stocks, although individual companies can respond very differently depending on their financial position and business performance.
Value Stocks and Economic Conditions
Value stocks can sometimes perform differently from growth stocks during different economic environments.
Companies classified as value stocks are often found in established industries such as financial services, energy, industrials, and consumer goods, although value investing can apply across virtually any sector.
If economic activity strengthens, certain value-oriented companies may benefit from increased demand, higher commodity prices, stronger lending
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