Value vs. growth stocks: Which should you invest in?

When you're deciding how to invest your retirement savings, you have a choice of philosophies to embrace. Two of the most popular styles are value and growth investing, and they each look at your risk tolerance, time horizon and values in different ways. You can align which assets you add to your portfolio based on how they mesh with your financial plan—and adjust that over time.

To start, understanding how value vs. growth stocks compare can help you decide which strategy, or combination of the two, might be right for you.

When you think of the word "value," you likely imagine a good bargain or paying less for something than it's really worth. That's the idea behind value stocks as well—they're trading at less than their true, or intrinsic, value. In other words, they're selling for a bargain price. To determine if a stock belongs in the "value" category, analysts look to financial ratios like price to earnings or book value per share.

To illustrate the idea, let's use an example of the price to earnings (PE) ratio. This compares the current stock price and the company's earnings. It's calculated by dividing the stock price by the company's earnings per share. So, if a stock is currently trading for $50 and has earnings per share of $4, then its price to earnings ratio is 50/4, or 12.5.

Suppose analysts believe that the stock should be trading at a PE ratio of 17. That would imply the stock's true worth is $68 per share, based on its current $4 of earnings per share. This stock is undervalued. Value investing is about buying undervalued stocks and holding them until their price reaches their intrinsic value.

Growth stocks are seemingly poised for growth due to their business strategy, product offering or performance. Growth stocks are often trading at prices above their intrinsic value because investors believe they'll earn an above-average return on these stocks and are willing to pay more for them. Because prices in the stock market are based on supply and demand, this increased buying pressure pushes up the stock's market price.

Again, we can use the PE ratio to identify a growth stock. Growth stocks often have PE ratios that are much higher than their intrinsic value suggests. For example, that company with $4 of earnings per share that analysts suggest should trade at a PE ratio of 17 might, in fact, be trading for $108 if it's a growth stock. That would give it a PE ratio of 27.

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Does your investment portfolio match your risk tolerance?

Risk and reward often go hand in hand, especially when it comes to investing in the stock market. A foundational element of investing is understanding your tolerance of risk and what helps shape it.

Dive deeper

The main factors that set value and growth stocks apart are their relative valuations, the company's stage of business, and what the companies do with their cash flow.

Although some stocks clearly fall into one category or the other, the distinction isn't necessarily absolute. Some stocks may have characteristics of both styles. Think of the differences between the two as shades of gray that exist on a scale rather than a hard dividing line.

Value stocks trade at prices below their intrinsic value. Relative to their earnings and other financial metrics, value stocks usually have lower prices.

Growth stocks are often priced much higher than their intrinsic value because investors believe the company will experience above-average growth. Value stocks often have low PE ratios, while the PE ratios of growth stocks can be quite high.

How you interpret these valuation differences is a matter of perspective. Relatively low valuations could be an indicator of value and represent a bargain buy, or it could mean that the market doesn't expect much from the stock. Stocks with relatively high prices relative to fundamentals could be viewed as overpriced, but it could also mean that investors believe the stock shows exceptional promise.

Value stocks often stem from mature companies that have peaked in terms of growth. They usually have a strong and stable market share with reliable earnings, low debt and solid cash flow. Value stocks perform well during periods of high inflation and can be used as an inflation hedge.

Companies with growth stocks are often earlier in the business life cycle and still gaining market share. They may have higher amounts of debt and lower earnings and cash flow. Inflation tends to hurt growth stocks, and they often do poorly in high interest rate environments.

These differences suggest that value stocks may be a better fit than growth stocks for someone with a lower risk tolerance, and their prices will be less volatile.

Because value stocks typically represent well-established companies that aren't growth-oriented, they often use their cash to pay dividends rather than reinvesting in the company.

It's more likely that growth stocks will have a higher degree of retained earnings and lower dividend payouts. Because growth is the objective, they need to invest capital into projects expected to expand the company.

If you want your investments to provide a ready stream of cash flow through dividends, value stocks will probably be a far better choice than growth stocks.

Whether you choose to invest in growth or value stocks is a matter of personal choice and your goals. If you want a stable portfolio that provides cash flow from dividends, then value stocks may be what you need. If you're looking for long-term growth and don't mind less cash flow and more volatility, then growth stocks may provide that for you.

While people debate whether value stocks are riskier than growth stocks, or vice versa, both types actually may have a place in your portfolio. Holding each can provide an additional layer of diversification that reduces your total investment risk. All in all, it's a decision that could benefit from another perspective. A Thrivent financial advisor can think through your financial plan, time horizon and risk tolerance to help you make the right choice.