Value and growth: two bets on the same page

Start with what a share is: a claim on what a company earns, now and in the future. Every price paid for one is therefore a statement about those earnings. Value and growth are two different statements, and the disagreement between them is the most durable argument in investing.

The question both labels answer

The question is: how much of the price is justified by what the company earns today, and how much depends on what it earns later.

A value approach pays a low price relative to what the business currently produces, on the reasoning that today is more knowable than tomorrow and that pessimism can be overdone.

A growth approach accepts a high price relative to today, on the reasoning that the business will be much larger later and that todays figures understate it.

Both can be right. Both can be wrong. And critically, neither is a description of a type of company: it is a description of the relationship between a price and a set of figures, which means the same company can sit in either camp at different prices.

Price to earnings, worked out

One ratio does most of the work in this conversation. The price to earnings ratio is the price of one share divided by the earnings attributable to one share.

Read the ratio as a sentence and it stops being intimidating: at a ratio of 15, you are paying fifteen years of current earnings for the shares. At 30, you are paying thirty. That does not make 30 wrong. It means more of that price depends on earnings that have not happened yet.

Two cautions belong immediately next to any such ratio. Earnings are an accounting figure with real judgement inside them. And a ratio is meaningless in isolation: it only says something when compared with the same company over time or with genuinely similar businesses.

What the value approach is betting on

That the market has become too pessimistic about something knowable, and that the gap closes.

The attraction is that the starting price contains modest expectations, so being wrong is less punishing. The characteristic failure is the value trap: something looks cheap relative to current figures because the business is genuinely deteriorating, and the figures fall to meet the price rather than the other way around. Cheap and declining is not the same as cheap and misunderstood, and telling them apart is the entire job.

What the growth approach is betting on

That the business will be substantially larger later, and that todays high price will look modest against future earnings.

The attraction is that a business genuinely compounding its own earnings can grow into almost any starting price given enough time. The characteristic failure is that the price already contains a great deal of optimism, so merely good news is bad news. When a high expectation is not met, prices adjust sharply, and that is a mechanical consequence of how much of the price was resting on the future.

Why the labels blur in practice

Three reasons, and each one is a good reason not to treat the labels as identities.

• Price changes the label. A company can be a growth holding at one price and a value holding at a price 60 percent lower, without anything changing inside the business.
• The measures disagree. Different measures of cheapness classify the same company differently, so two published lists of value holdings can overlap surprisingly little.
• Growth is part of value. Any serious estimate of what a business is worth already includes assumptions about its future growth. The two ideas are not opposites; they are two ends of a single calculation.

You will also see periods described as favouring one or the other, sometimes for many years at a stretch. That is a fact about the past. Nothing on this site suggests which will lead next, because nobody knows.

What this means for a beginner

Mostly, that it can wait. This distinction becomes actionable when you are choosing between individual companies, and most beginners are not. A broad fund holding a wide market already contains both, in whatever proportion the market currently holds, which is a defensible position rather than a fudge.

What is worth taking from this page immediately is smaller and more useful: a price contains an expectation. When something has risen a great deal, more of its price rests on the future being excellent. When something looks cheap, the market is pricing in a reason. Neither observation tells you what to do, and both stop a chart from looking like a verdict, which is the argument in how to read a stock chart.

If the aim is a first portfolio rather than a first company, the decisions that actually change your outcome are set out in investing for beginners, and none of them is this one.

This page describes two ways of thinking about price and contains no view on any company, sector or market. The arithmetic uses an invented company to isolate a calculation, and nothing here is a recommendation to buy or sell.