Before investing you must choose the plan of action. Understanding the different routes in fundamental analysis is a key to create a positive return on your investments.
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This article provides an explanation on the basic concepts of three well-known investment styles: ‘Value’, ‘Growth’ and ‘Income’ investing. Furthermore, you will get insight into why they are used and exactly what factors to look for in all three of them.
What stocks should I hold in my portfolio?
Performance of value and growth stocks moves in cycles because different market conditions affects value stocks differently than growth stocks. Historically, growth stocks tend to perform better in prospering economy, while value stocks tend to outperform when the economy is in neutral or climbing out of a recession.
Since it is very difficult to both keep a close eye on micro and macro factors, it is for a great benefit to include both value, growth and income stocks in your diversified portfolio. Diversifying across investment styles may also help mitigating the risk.
There are alternative types of investment styles that can be applied to individual stocks, as well as sectors. Investors are commonly characterized according to what investment style they utilize.
1. Value investing
Value investing is an investment style that focuses on buying a stock that is undervalued according to a fundamental analysis, and hold that stock until it has reached its true value. Accordingly, value stocks are presumed to be traded at discount to their true value.
The interpretation of value investing can differ from investor to investor. Some value investors observe past and present fundamentals without considering much about future growth while others base their strategies completely on the estimation of future growth and forward-looking fundamentals. Despite these differences, the value investing concept always seeks to buy a stock for less than it is worth.
How to find Value stocks
Value stocks are typically identified by using ratios such as low price-to-earnings (P/E), price-to-book (P/B) and P/E-to-Growth (PEG) and furthermore high dividend yield.
A price-to-earnings (P/E) ratio is found by dividing a share price by itsearnings per share (EPS) and it is an easy way to get a quick look of a stock’s value. A particularly high P/E indicates that the stock is overvalued and relatively risky; hence value investors typically look after a low P/E ratio. The drawback of the P/E ratio is that it does not account for growth. Accordingly, a low P/E may seem attractive but if the company is not growing, its stock’s value is also not very likely to rise.
A price-to-book (P/B) ratio is used to compare a stock’s market value to its book value. It can be calculated as the current share price divided to the book value per share, according to previous financial statement. In a broader sense, it can also be calculated as the total market capitalization of the company divided by all the shareholders equity. This ratio gives certain idea of whether you are paying too high price for the stock as it denotes what would be the residual value if the company went bankrupt today.
A higher P/B ratio than 1 denotes that the share price is higher than what the company’s assed would be sold for. The difference indicates what investors think about the future growth potential of the company.
2. Growth Investing
Growth investing consists of identifying stocks that have exhibited faster-than-average earnings growth over the previous few years, compared to the market, and are furthermore expected to continue this earning growth in the coming future.
Why invest in growth stocks?
Growth stocks are thought of as riskier than average stocks since they usually have high price-to-earnings (P/E) ratio and pay little or no dividends to their shareholders. On the other hand, if you pick a good growth stock it has the possibility to multiply in value. Investors are thus willing to pay higher share price for the stock’s future growth potential.
Growth investors seek to make capital gains from a higher share price, as opposed to for example receiving dividend payments for income. A growth stock does not pay dividends because the company prefers to reinvest it’s earnings to keep growing and expending its business.
Since the P/E ratio does not account for growth it is not very appropriate measure for growth stocks. In order to account for growth, the P/E ratio can be modified into the Price/Earnings to Growth (PEG) ratio. A PEG ratio is calculated by dividing the stock’s P/E ratio by its expected 12 month growth rate. A common rule of thumb is that the growth rate ought to be roughly equal to the P/E ratio and thus the PEG ratio should be around 1. A relatively low PEG ratio indicates an undervalued stock and a PEG ratio much greater than 1 indicates an overvalued stock.
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The PEG ratio can be very informative figure, as in this one ratio you get an understanding of the company’s earnings, growth expectations and whether it is trading at a reasonable price relative to its fundamentals.
When investing in growth companies, the following two factors might be useful to consider:
- Rapid growth does not continue indefinitely
- With larger business expansion a more complex and challenging business structure follows for the management
Note that individual ratios are absolute values, which on their own do not give much information; hence investors usually look for relative values. When these figures are compared to the company’s historical figures or to their peers (other companies in similar business and market environment) they become relative values. By using relative values, it is a possibility to identify growth stocks that are relatively undervalued versus their peers.
3. Income investing
Income investing consists of identifying stocks that pay relatively high and regular dividend payments to their shareholders. Well established income stocks often have a long history of paying out dividends and a track record of regularly increasing dividend ratios is a sign of high-quality income stock. These are usually mature companies that have reached a certain size and can no longer sustain previous high level of growth.
Some sectors are known for income generating stocks and are popular for income investors. These sectors are such as; gas, electric, telecommunication, real estate investment trusts, financials, insurance sectors.
Why income investing?
Income investing is in many ways similar to value investing, where unlike growth stocks, the aim of an income investing portfolio is to generate cash instead of focusing on generating capital gains via higher share price.
What factors to look at?
It is not sufficient to only look at dividend payments in ‘dollar’ terms, rather income investors look at dividend yields. Dividend yield is calculated by dividing annual dividend per share (DPS) to the current stock price. This gives the actual return from the dividends, which is comparable with companies of different size. Average stocks generate dividends of about 2-3 percent per share and income stocks usually provide dividends of around 5-6 percent per share.
Although it is good to be on the lookout for companies that have high dividends ratios, it is important to note that too high payout ratios need to be considered with caution. A company with high payout ratio (characterized by 60 percent of earnings and above) can probably not sustain these high payouts and might need to lower its payout ratio again. It is considered a bad sign to the market when a company needs to lower its payout ratio. Therefore, the highest ratios are not the most likely to sustain a continuously payouts, the ones lying between 40-60 percent of earnings are more likely.
A company’s past dividend policy is a therefore a factor that income investors consider alongside the dividend yield. A dividend policy provides information of whether the company will continue to pay out its dividends or reinvest its retained earnings. A large and swiftly increase in dividend payments over a short period needs to be examined with caution, since the company might be too optimistic about their future prospects. Therefore, it is very informative to look at the historical dividend policy, the longer the company has been paying high dividends, the more likely it will maintain that trend. Companies that have had a steady record of paying out dividends for the previous 5, 10 or 20 years would be classified as well-established dividend record.
Look for the relationship between DPS and EPS
In addition to the dividend yield and policy, one last factor that should be encountered for when practicing income investing is the DPS versus the earnings per share (EPS). Dividends are paid out as a percentage of the earnings so due to this close relation a good rule of thumb is that the annual growth in DPS should not exceed the annual growth in EPS. If the company’s DPS increased more than its EPS each year, then the company would be left with no earnings to reinvest in its own growth the years ahead.
After an investor have identified a company that pays constant dividends he does not need to worry about short-term market fluctuations since he receives a steady flow of money every year.
(This article appeared on Euro Investor)