Growth vs value stocks

Two styles

Investors often split stocks into two styles:

• Growth stocks — companies whose revenue grows 15–20% a year or faster. They don't pay profit out as dividends; they reinvest it in more growth. Their multiples (P/E, P/S) are usually high, because the market pays up front for future profit.
• Value stocks — mature companies growing slowly but steadily. Their multiples are low and they often pay a dividend. Here the investor bets that the business is better than its low price implies.

Index providers draw the line with metrics: for value — P/E, P/B, dividend yield; for growth — revenue and EPS growth. But the line is not hard: many companies sit in the middle, and some move from one style to the other over time. The in-between approach that combines growth with a sensible price is called GARP (growth at a reasonable price).

On the chart both companies start with the same $100m of revenue. The growth company reaches $400m in five years (~32% a year), the value company $121m (~4% a year). The market gives the first a high P/E, because in five years its profit could be several times larger. The second is cheaper but often pays cash — a dividend — today.

Metrics for each style

When assessing a growth company:

• Revenue growth (annual and quarterly), how steady it is and whether it is slowing.
• Gross margin — if high, growth can turn into profit more easily later.
• Margin expansion — is operating margin rising year after year (the operating leverage from the Fundamental analysis basics lesson)?
• P/S and PEG — price relative to growth (the Valuation lesson).
• Market size (TAM) — how much room the company has to grow.

When assessing a value company:

• P/E, P/FCF, EV/EBITDA — versus the industry and the company's own history.
• Stable FCF, and whether FCF covers the dividend.
• The balance sheet — debt and interest coverage (the Financial health lesson).
• Whether revenue and margins are not falling — the reason it is cheap.

Growth quality

Not all growth is good. Ask three questions.

1. Can growth turn into profit?

A popular rule of thumb in software is the "rule of 40": revenue growth (%) + FCF margin (%) ≥ 40.

On the chart A grows 35% a year with a 10% FCF margin: a total of 45 — above the rule. B grows fastest (50%) but loses $25 on every $100 of sales: 50 − 25 = 25. C is slower (15%) but very profitable (30%): a total of 45. So B's growth is "expensive" — it is being bought by burning cash. The rule is industry-specific and rough, but it shows the balance between growth and profit well.

2. Are margins expanding?

In a quality growth company margins rise as it scales: R&D and overhead grow more slowly than revenue. If revenue grows 30% and operating losses grow too, the business model is not yet proven.

3. Is there room to grow (TAM)?

Example: a company's revenue is $2bn and its market (TAM) is $10bn — a 20% share. The price assumes 30% growth a year. In five years revenue would have to be $2bn × 1.3⁵ ≈ $7.4bn — 74% of today's market. Unless the market itself grows fast, that is nearly impossible. So the expectations in the price may be far too optimistic.