Investors who want to build profitable portfolios should consider growth stocks vs. value stocks—and then buy some of both.

Investors who want to build profitable portfolios should consider growth stocks vs. value stocks—and then buy some of both.

One of the sweetest and most profitable pleasures of successful investing is to buy high-quality “value stocks” (or stocks that are reasonably priced, if not cheap, in relation to its sales, earnings or assets), then hold on to them as mainstream investors recognize the value and push up the share price.

Growth investing, on the other hand, focuses on trying to identify and buy rising stocks when they have further growth ahead. Although these stocks can be volatile, and some investors may see them as vehicles only for short-term wins and losses, they often make good long-term investments, too.

What are growth stocks?

These stocks may trade at higher-than-average multiples of earnings, cash flow, book value and so on. Ideally, though, they also have above-average growth prospects, compared to alternative investments.

By definition, growth stocks are companies that have above-average growth prospects. They are firms whose earnings growth has been above the market average, and is likely to remain above average. It is also often the case that they pay small dividends or none at all. Instead, they re-invest their cash flow in the business, to promote their growth.

They may be well-known stars or quiet gems, but they do share one common attribute—they have grown at higher-than-average rates within their industries, or within the market as a whole, for years or even decades.

Dividend growth stocks are a welcome bonus—but focus on quality

Dividend growth stocks offer investors a measure of security. Dividends, after all, are much more stable than earnings projections. More important, dividends are impossible to fake—either the company has the cash to pay them or it doesn’t.

However, it’s important to avoid judging a company based on the fact that it pays a dividend. Nor should you be tempted solely by a high dividend yield (the percentage you get when you divide a company’s current yearly payment by its share price).

That’s because high yield can sometimes be a danger sign rather than a bargain. For example, a dividend stock’s yield could be high simply because its share price has dropped sharply (since you use a company’s share price to calculate yield). That drop may signal investor anticipation of coming bad news, including a dividend cut.

As well, you should always remember that while growth stocks hold the potential for greater gains than conservative selections, they typically expose you to a higher level of risk—even if they are dividend-paying stocks.

That’s why we look beyond dividend yield when making investment recommendations, and look for dividend stocks that have established a business and have at least some history of building revenue and cash flow.

Growth stocks vs. value stocks: Look for hidden assets when evaluating either type of stock

If you buy a stock for its hidden assets, but those assets stay hidden or ignored by investors— or turn out to be less valuable than you thought—it can’t hurt you much. By definition, a stock’s hidden assets have not had much impact on its price. If you paid little if anything for the assets, you have little to lose. But the best hidden assets will eventually expand a company’s profit, grab investor attention, and push up its stock price.

Stocks with hidden assets are not rare, but they’re hard to find. But when you know what to look for, you can discover them.

Here are three financial ratios we use as a guide to evaluating stocks, especially value stocks, which often have hidden assets.

1. Price-earnings ratios: The p/e is the ratio of a stock’s market price to its per-share earnings. As a general rule, the lower the p/e, the better, and generally a p/e of less than 10 represents excellent value. We calculate each p/e ratio using the most recent financial data.
2. Price-to-book-value ratios: The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding. Book value per share gives you a rough idea of the stock’s asset value. This ratio represents a “snapshot” of an instant in time, and could change the next day. Note, though, that asset values on a company’s books are the historical value of the assets when they were originally purchased, minus depreciation.
3. Price-cash flow ratios: Cash flow is actually a better measure of a company’s performance than earnings. While reported earnings are subject to accounting interpretation and can be restated in later years, cash flow is a measure of the cash flowing into a company less cash outlays. Simply put, it’s earnings without taking into account non-cash charges such as depreciation, depletion and the write-off of intangible assets over time.

Have you ever evaluated growth stocks vs. value stocks before? Do you own either growth stocks or value stocks? Share your experience with us in the comments.