A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share (EPS) and book value. While investing in growth companies can help aggressive investors beat the market, a company's fast growth is often priced into its stock, making it difficult to distinguish between a good buying opportunity and an overvalued stock. By evaluating a company's growth in conjunction with its stock's valuation, you can identify stocks that have high capital appreciation potential but are not overvalued.
Despite having starkly different profiles, growth stocks and value stocks do not represent opposites, nor are they mutually exclusive. A growth stock is a stock in a company with earnings and revenues that are growing at a fast rate. Because stock prices frequently rise in concert with earnings and revenues, investors gravitate toward growth stocks when they want to beat the returns being offered by the broader market. Growth stocks typically do not pay dividends; growth companies prefer to reinvest profits back into their operations to fuel expansion rather than distributing them to shareholders.
Value stocks trade at lower share prices compared to stocks of peer companies with similar fundamentals. The goal of value stock investing is to identify fundamentally sound companies that the rest of the market has yet to discover and, therefore, are priced lower than they should be. Stocks of growth companies can also be value stocks, as can dividend-paying stocks of mature blue-chip companies. It all depends on how the share price compares to the company's fundamentals.
The way to determine whether a stock is undervalued, overvalued or valued just right is to consider its valuation measures, most notably its EPS and price-to-book (P/B) ratio. These metrics indicate whether you are paying more, less or about the same as you would to invest in a company with similar fundamentals.
The price-to-earnings (P/E) ratio indicates how many multiples of the company's EPS its stock price is trading at. Across the board, the average P/E ratio is about 15. Therefore, if a company's EPS is 2, you would expect its stock to trade at $30 per share if the stock is moderately valued. Average P/E ratios vary by industry. To determine how appropriately a stock is valued, it is more beneficial to compare the P/E ratio with peer companies in the same industry as opposed to broader averages.
The P/B ratio compares a company's market value to its book value. It compares how investors value a company to what the company is actually worth from an accounting perspective. Market value is determined by multiplying a company's share price by the number of common shares outstanding. If a stock is trading at $20 per share and the company has 1 million common shares outstanding, the company's market value is $20 million. To determine the book value, look at the company's balance sheet and subtract the total liabilities from the total assets. An even easier way is to look at shareholders' equity, which is the same thing as book value. Value investors typically want to see a P/B ratio under 3, meaning the company's market value is no more than triple its book value.
To identify a growth stock that is also a good value buy, seek out potential growth companies by looking at year-over-year revenue and earnings growth. If both values are above 20%, you are probably looking at a viable growth company. Next, conduct fundamental analysis as described above and determine how each company is valued based on its P/E and P/B ratios. A growth stock that also has low valuations represents a good value buy.