Stocks · Intermediate · 5 min

Value vs. growth

You can calculate a price-earnings ratio, explain what separates value from growth stocks, and say what each style depends on.

Cheap or expensive?

People call shares cheap or expensive all the time. Often they mean the share price: 5 sounds cheap, 500 sounds expensive. As you saw at the start of this rubric, the price alone says nothing.

What investors actually compare is the price against what the company earns. That single comparison splits the stock market into two broad styles, value and growth, which behave differently and attract different investors.

Today vs. tomorrow

The price-earnings ratio, or P/E, divides the share price by the earnings per share. A P/E of 15 means investors pay 15 for every 1 of yearly profit. It lets you compare companies of any size and share price.

A value stock has a low price compared with its current profits, its assets or its dividends. These are often mature companies in established industries, with slower growth and often higher dividends. The market is pricing them mainly for what they earn today.
A growth stock has a high price compared with current profits, because investors expect strong growth in the future. These companies often pay little or no dividend and reinvest their profits.

Index providers sort stocks into the two styles by fixed rules. MSCI, for example, measures value with three ratios: book value to price, expected earnings to price and dividend yield. Growth is measured with the expected and past growth of earnings and sales. S&P Dow Jones Indices publishes value and growth versions of its US indices by similar logic.

Both styles carry their own risk. A low P/E can be low for a good reason: the market may expect profits to fall. Investors call a cheap share that stays cheap a value trap. A high P/E depends on growth actually arriving. If it disappoints, the price can drop sharply, even if the company is still growing.

Over the decades, value and growth have taken turns. Long periods have favored one style, then the other.

P/E 10 vs. 60

A fictional value company trades at 40 and earns 4 per share: a P/E of 10.
A fictional growth company trades at 120 and earns 2 per share: a P/E of 60.

If the growth company doubles its profit to 4 per share and the price stays at 120, its P/E falls to 30. If its profit stays at 2 and investors lose patience, a P/E of 30 would mean a price of 60, half the current level.

The value company's price depends more on keeping its profit stable. The growth company's price depends on the future arriving as hoped.

Common mistakes

Calling a low share price cheap. Compare the price with the earnings, not with other prices.
Treating a low P/E as a bargain. It may signal falling profits ahead.
Assuming growth always wins. High expectations can turn into large losses.
Comparing P/E across very different sectors. Normal levels differ between industries.

The takeaway

Value stocks look cheap relative to today's profits, growth stocks are priced for tomorrow's. Neither style wins every year.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the style whose price depends most on future profits.

Tap the chart.

Growth stocks are priced for strong profit growth. If that growth disappoints, the price can fall sharply.
2A share costs 120 and earns 2 per share. What is its price-earnings ratio?

P/E = share price ÷ earnings per share: 120 ÷ 2 = 60. Investors pay 60 for every 1 of current profit.
3Which measures does MSCI use to identify value stocks?

MSCI's value and growth methodology scores value on these three measures, and growth on expected and past growth of earnings and sales.
4Is a low P/E always a bargain?

A low P/E can reflect real problems. Investors call a cheap stock that stays cheap for good reason a value trap.

of 4 correct.