"Growth" and "value" are thought of as two very significant metrics in the world of fundamental analysis, two things that can cause a trader to buy, sell, or ignore. But what is growth? And what is value? These are words we hear and read every day, and that most people think they can easily define. You might think that a musician's songwriting has grown, or you might give (or get) what you believe to be valuable advice. But in both of these instances, growth and value are subjective—matters of perception.
But when it comes to the markets, growth and value are not so subjective. Rather, they are things that, for the most part, can be measured or weighed. Growth refers to a company's performance, whereas value applies to its stock price. Moreover, there are very specific ways of gauging growth and value. Here we'll discuss seven popular ways of doing just that.
Growth: Past, present, and future
In simple terms, growth describes earnings. There are three different ways of looking at those earnings: past, present, and future.
1. The past: Historical growth
As the common disclaimer goes, "past performance is not indicative of future results." And as true as that may be, it doesn't mean that it's not good to know a company's past. With that in mind, many traders and investors look at a company's historical growth, which is really just a catchy way of describing the company's annualized earnings in the past. When there exists a consistent increase in annualized earnings, there exists historical growth.
2. The present: Free cash flow
When it comes to measuring growth (or growth potential), some traders and investors like to follow the cash or, more specifically, the free cash flow. Free cash flow is, put simply, the difference between cash in and cash out. When there's significantly more cash coming in, the free cash flow is strong. When the cash coming in is close to (or less than) the cash going out, the free cash flow is weak. Companies with strong free cash flow may have capital for R&D, acquisitions, etc. In other words, things that may very well help it grow.
3. The future: Projected growth
If you're going to look back, you may also want to look ahead. But where a company's historical growth can be calculated by looking at their past performance data, a company's projected growth is determined by analysts who look at a variety of information, including a company's current and recent finances, as well as its stated objectives and outlooks.
Value: Price comparisons
Growth places a heavy emphasis on, of course, growing. Value, however, does not. (After all, not every company aims to keep expanding, or even growing, its earnings. Some companies, whether they want to or not, just stay relatively consistent.) Value looks at the price of the company's stock relative to the performance of the company, regardless of whether or not the performance is improving. Here are four popular ways of gauging the value of a stock.
1. Price to earnings ratio (P/E)
This metric takes the stock's price and compares it to the company's earnings. It does that by dividing the stock price by the earnings per share (EPS). A “normal” P/E ratio is typically 20–25 times higher than the EPS. So a stock with a “normal” P/E ratio may be trading at $20/share, and have an EPS of $1/share. In this case, the P/E ratio is 20. Perhaps you can see where this is going: If a company is earning more money per share, but it’s not reflected in the stock price, the P/E ratio can be low (lower than 20), and this can suggest that a stock is undervalued (and thus, may be a good buy). For example, remember the example stock that was trading at $20? Now, let’s say its EPS is $5. The P/E ratio for that stock would be 4, which may suggest the stock price should go up to reach normal range. Or, consider the reverse: the stock is trading at $20, but the company is only earning $0.50/share. Now it has a P/E ratio of 40, which suggests the stock may be overvalued.
2. Price to book ratio (P/BV)
To arrive at this measurement, you have to consider a hypothetical, which is to say, you have to know its book value. A company's book value is the theoretical amount that every share would be worth if the company were to be completely liquidated. That number is then compared to the actual share price of the company. The result is the P/BV, or Price to Book Ratio. If the ratio is low (meaning the price is lower than the book value), the stock may be undervalued.
3. Price to sales ratio (P/S)
How does a company make money? One major way is by selling, some in a traditional retail sense, and others in a more abstract sense (by selling its ideas or services). Regardless, since sales are often a significant source of money for a company, many traders and investors like to compare a company's sales to its stock price. Here they do this by actually breaking down the sales to a per-share amount. With this figure, they formulate the Price to Sales Ratio. Like the above two ratios, a comparatively low stock price means a low ratio, which may be indicative of an undervalued stock.
4. Dividend yield and historical rate of dividend growth
Since dividends are cash payouts that companies pay their shareholders, dividends can be an important thing to many traders and investors. For one thing, dividends can allow a shareholder to earn income without actually selling the stock. And for another, the amount of dividends can be a good indicator of the health of the company. To take a deeper look, many users of fundamental analysis will look at a company's dividend payment history. Consistent and increasing dividends may be a sign of a strong company, and a stock price that has not grown along with those dividends may be a sign of an undervalued stock.
So, in the end, when you think about growth and value, think about these seven points. For growth, there's the past, the present, and the future. And when it comes to value, do price comparisons—against earnings, against book value, against sales, and against dividend yields.