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What is a ‘Growth Stock’
A growth stock is a share in a company whose earnings are expected to grow at an above-average rate relative to the market.
A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects. Growth investors choose stocks based on the potential for capital gains, not dividend income, so they can be risky.
BREAKING DOWN ‘Growth Stock’
Technology companies are typically good examples of growth stocks because the opportunity for advancement is virtually limitless. However, growth stocks also carry a lot of risk because shareholders rely solely on the company’s success to generate return on their investment. If the company’s growth is not what was expected, shareholders may end up losing money as market confidence wanes and share prices drop.
Characteristics of Growth Stocks
While many promising small-cap stocks may be considered growth stocks, not all growth stocks are issued by small companies. One competitive advantage that is common among growth stocks is manufacturing scale. Because producing many items is typically cheaper than manufacturing just a few, the economies of scale enjoyed by larger companies often mean that they can keep more of their revenues as profit, accelerating growth.
Growth stocks also often share a few other common traits that are independent of company size. Growth companies typically either have a very loyal customer base or a firm grasp on the majority market share. This could mean that the company is the first to offer a given product or service (likely a smaller company in a newer industry), or that it is simply the most popular company among many (a large company dominating its market).
Growth companies also typically have unique or advanced product lines. A growth company may hold a patent for a new and promising technology or product or have a history of being at the forefront of industry developments. This is the primary reason that growth companies do not pay out dividends. The company’s goals are best served by reinvesting its earnings into product research and development, thereby fueling expansion.
Growth vs. Value
The distinction between growth and value stocks is very important in investing. While growth stocks are those that are anticipated to generate substantial capital gains, value stocks are those that the market sees as underrated or ignored. Growth stocks are often overvalued because the market sees them as money-makers. Value stocks, by definition, are undervalued.
While value stocks may be underpriced due to disappointing earnings reports, negative media attention, or legal troubles, they still have good financials and a solid dividend payout history. A consistent dividend track record is crucial to a value stock as it is this reliable investment income that tells investors the stock is worth buying. Value stocks are rarely glamorous and are often older companies that, while they won’t be going anywhere soon, aren’t exactly on the cutting edge of industry innovation.
Typically, prudent investors hold a combination of growth and value stocks to capitalize on the benefits of both investment types.
What is a ‘Value Stock’
A value stock is a stock that tends to trade at a lower price relative to its fundamentals (e.g., dividends, earnings and sales) and thus considered undervalued by a value investor. Common characteristics of such stocks include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio. An easy way to attempt to find value stocks is to use the “Dogs of the Dow” investing strategy by purchasing the 10 highest dividend-yielding stocks on the Dow Jones at the beginning of each year and adjusting the portfolio every year thereafter.
BREAKING DOWN ‘Value Stock’
A value stock is a security trading at a lower price than how the company’s performance may otherwise indicate. Investing in a value stock attempts to capitalize on inefficiencies in the market as the price of the underlying equity may not match the company’s performance.
Two Approaches to Selecting Stocks
The two basic approaches for equity investing relate to purchasing growth stock or value stock. Growth stocks are equities of companies with strong anticipated growth potential. Value stock emphasis equities that are currently undervalued. A balanced diversified portfolio will have both value stock and growth stock. These portfolios may be referred to as a blended portfolio.
How to Spot Value Stocks
A value stock will have bargain-price as the company is seen as unfavorable in the marketplace. A value stock will have an equity price lower than stock prices of companies in the same industry. Negative publicity relating to unsatisfactory earnings reports or legal problems are indicators of a value stock as the market will negatively view the company’s long-term prospects. A value stock will most likely come from a mature company with a stable dividend issuance that is temporarily experiencing negative events. However, companies that have recently issued equities have high value potential as many investors may be unaware of the entity.
Risk and Return of Value Stocks
A value stock is considered riskier than a growth stock. This is because of the skeptical attitude the market has towards the value stock. For a value stock to turn profitable, the market must alter its perception of the company, which is considered riskier than a growth entity developing. For this reason, a value stock is typically more likely to have a higher long-term return than a growth stock because of the underlying risk. The investing duration must be taken into consideration a value stock may need some time to emerge from its undervalued position. The true risk in investing in a value stock is that this emergence may never materialize.
What is a ‘Value Fund’
A value fund is a stock mutual fund that primarily holds stocks that are deemed to be undervalued in price and that are likely to pay dividends. Value funds are one of three main mutual fund types; the other two are growth and blend (a mix of value and growth stocks) funds.
What is a ‘Mutual Fund’
A mutual fund is an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers, who invest the fund’s capital and attempt to produce capital gains and income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.
One of the main advantages of mutual funds is that they give small investors access to professionally managed, diversified portfolios of equities, bonds and other securities, which would be quite difficult (if not impossible) to create with a small amount of capital. Each shareholder participates proportionally in the gain or loss of the fund. Mutual fund units, or shares, are issued and can typically be purchased or redeemed as needed at the fund’s current net asset value (NAV) per share, which is sometimes expressed as NAVPS.
DEFINITION of ‘Mutual Fund Yield’
Dividend payments divided by the value of a mutual fund’s shares. Mutual fund yield is different from a fund’s market value, which is typically determined after the market closes each day and the fund reconciles its positions. It is also different from the fund’s return, which takes into account both dividend payments and changes in share price.
DEFINITION of ‘Family Of Funds’
Also referred to as a “mutual fund family” or simply a “fund family”.
BREAKING DOWN ‘Foreign Fund’
Foreign funds offer individual investors access to international markets. Investing abroad poses risks, but can also help investors diversify their portfolios.
It is important to recognize the difference between global funds and foreign funds. Global funds can invest in securities from any country, including the investor’s home country.
DEFINITION of ‘Global Fund’
A type of mutual fund, closed-end fund or exchange-traded fund that can invest in companies located anywhere in the world, including the investor’s own country. These funds provide more global opportunities for diversification and act as a hedge against inflation and currency risks.
What is a ‘Bull Market’
A bull market is a financial market of a group of securities in which prices are rising or are expected to rise. The term “bull market” is most often used to refer to the stock market, but can be applied to anything that is traded, such as bonds, currencies and commodities.
BREAKING DOWN ‘Bull Market’
Bull markets are characterized by optimism, investor confidence and expectations that strong results will continue. It’s difficult to predict consistently when the trends in the market will change. Part of the difficulty is that psychological effects and speculation may sometimes play a large role in the markets.
The use of “bull” and “bear” to describe markets comes from the way the animals attack their opponents. A bull thrusts its horns up into the air while a bear swipes its paws down. These actions are metaphors for the movement of a market. If the trend is up, it’s a bull market. If the trend is down, it’s a bear market.
Learn how you can profit in a bull market by reading Banking Profits in Bull and Bear Markets and also How to Adjust Your Portfolio in a Bull or Bear Market.
DEFINITION of ‘Bull Position’
A long position in a financial security, such as a stock in the stock market. A bull or long position seeks to profit from rising prices in certain securities. When prices rise, a bull position becomes profitable. If prices fall, the bull position is not profitable. A bull or long position is the most well-known type of position and is what is typically used in “buy and hold” investing. An alternative way to initiate a bull position can include buying call options.
BREAKING DOWN ‘Bull Position’
A bull position is the opposite of a bear position. A bull position is a trade or investment that is initiated in the hopes that the instrument’s price will rise and make a profit. A bull market occurs when prices are rising, and is characterized by investor optimism and confidence that prices will continue to rise.
DEFINITION of ‘Trending Market’
A market that is trending in one direction or another. A bull market is trending upward, while a bear market is trending downward. A trending market can be classified as such for either the short, mid or long term.
What is a ‘Trend Analysis’
A trend analysis is an aspect of technical analysis that tries to predict the future movement of a stock based on past data. Trend analysis is based on the idea that what has happened in the past gives traders an idea of what will happen in the future. There are three main types of trends: short-, intermediate- and long-term.
DEFINITION of ‘Stock Analysis’
Stock analysis is a term that refers to the evaluation of a particular trading instrument, an investment sector or the market as a whole. Stock analysts attempt to determine the future activity of an instrument, sector or market. There are two basic types of stock analysis: fundamental analysis and technical analysis. Fundamental analysis concentrates on data from sources including financial records, economic reports, company assets and market share. Technical analysis focuses on the study of past market action to predict future price movement.
What is ‘Technical Analysis of Stocks and Trends’
Technical analysis of stocks and trends is the academic study of historical chart patterns and trends of publicly traded stocks. Technical analysis of stocks and trends employs the use of tools such as bar or candlestick charts and trading volumes to determine the future behavior of a stock. Much of this practice involves discovering the overall trend line of a stock’s movement.
What is ‘Fundamental Analysis’
A method of evaluating a security that entails attempting to measure itsintrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security’s value, including macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management).
The end goal of performing fundamental analysis is to produce a value that an investor can compare with the security’s current price, with the aim of figuring out what sort of position to take with that security (underpriced = buy, overpriced = sell or short).
This method of security analysis is considered to be the opposite of technical analysis.
What is ‘Financial Engineering’
Financial engineering is the use of mathematical techniques to solve financial problems. Financial engineering uses tools and knowledge from the fields of computer science, statistics, economics and applied mathematics to address current financial issues as well as to devise new and innovative financial products. Financial engineering is sometimes referred to as quantitative analysis and is used by regular commercial banks, investment banks, insurance agencies and hedge funds.
BREAKING DOWN ‘Financial Engineering’
Financial engineering has led to the explosion of derivative trading that we see today. Since theChicago Board Options Exchange was formed in 1973 and two of the first financial engineers, Fischer Black and Myron Scholes, published their option pricing model, trading in options and other derivatives has grown dramatically.
What is the ‘Enterprise Value (EV)’
Enterprise Value, or EV for short, is a measure of a company’s total value, often used as a more comprehensive alternative to equity market capitalization. The market capitalization of a company is simply its share price multiplied by the number of shares a company has outstanding. Enterprise value is calculated as the market capitalization plus debt,minority interest and preferred shares, minus total cash and cash equivalents. Often times, the minority interest and preferred equity is effectively zero, although this need not be the case.
- EV = market value of common stock + market value of preferred equity + market value of debt + minority interest – cash and investments.
BREAKING DOWN ‘Enterprise Value (EV)’
Enterprise value can be thought of as the theoretical takeover price if the company were to bought. In the event of such a buyout, an acquirer would generally have to take on the company’s debt, but would pocket its cash for itself. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm’s value.
The value of a firm’s debt, for example, would need to be paid by the buyer when taking over a company, thus enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation.
Enterprise Value As an Enterprise Multiple
Enterprise multiples that contain enterprise value relate the total value of a company as reflected in the market value of its capital from all sources to a measure of operating earnings generated, such as EBITDA.
- EBITDA = recurring earnings from continuing operations + interest + taxes + depreciation + amortization
The Enterprise Value/EBITDA multiple is positively related to the growth rate in free cash flow to the firm (FCFF) and negatively related to the firm’s overall risk level and weighted average cost of capital (WACC).
EV/EBITDA is useful in a number of situations:
- The ratio may be more useful than the P/E ratio when comparing firms with differentdegrees of financial leverage (DFL).
- EBITDA is useful for valuing capital-intensive businesses with high levels of depreciation and amortization.
- EBITDA is usually positive even when earnings per share (EPS) is not.
EV/EBITDA also has a number of drawbacks, however:
- If working capital is growing, EBITDA will overstate cash flows from operations (CFO or OCF). Further, this measure ignores how different revenue recognition policies can affect a company’s CFO.
- Because free cash flow to the firm captures the amount of capital expenditures (CapEx), it is more strongly linked with valuation theory than EBITDA. EBITDA will be a generally adequate measure if capital expenses equal depreciation expenses.
Another commonly used multiple for determining the relative value of firms is the enterprise value to sales ratio, or EV/Sales. EV/sales is regarded as a more accurate measure than the Price/Sales ratio since it takes into account the value and amount of debt a company has, which needs to be paid back at some point. Generally the lower the EV/sales multiple the more attractive or undervalued the company is believed to be. The EV/sales ratio can actually be negative at times when the cash held by a company is more than the market capitalization and debt value, implying that the company can essentially be by itself with its own cash.
What is ‘EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization’
EBITDA – Earnings before interest, taxes, depreciation and amortization is an indicator of a company’s financial performance which is calculated in the following manner:
EBITDA = Revenue – Expenses (excluding tax, interest, depreciation and amortization).
EBITDA is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
If you’re interested in learning how to calculate EBITDA using MS Excel we’ve got it covered.
BREAKING DOWN ‘EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization’
This is a non-GAAP measure that allows a greater amount of discretion as to what is (and is not) included in the calculation. This also means that companies often change the items included in their EBITDA calculation from one reporting period to the next.
EBITDA first came into common use with leveraged buyouts in the 1980s, when it was used to indicate the ability of a company to service debt. As time passed, it became popular in industries with expensive assets that had to be written down over long periods of time. EBITDA is now commonly quoted by many companies, especially in the tech sector – even when it isn’t warranted.
A common misconception is that EBITDA represents cash earnings. EBITDA is a good metric to evaluate profitability, but not cash flow. EBITDA also leaves out the cash required to fund working capital and the replacement of old equipment, which can be significant. Consequently, EBITDA is often used as an accounting gimmick to dress up a company’s earnings. When using this metric, it’s key that investors also focus on other performance measures to make sure the company is not trying to hide something with EBITDA.