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In this article, we will discuss about dividend and growth stocks in detail.
Growth stocks are those where expected earnings of the company would grow at a higher rate than the market. Those stocks belong to companies which have a high growth potential. Instead of distributing dividends, profits of the company are reinvested in capital projects as retained earnings. Owing to growth expectations, these stocks sell at premium value measured by price-earning ratio.
The stocks perform well when the economy is expanding rapidly. These companies have loyal customers and capture major share in the market. They may have unique/patented product offerings which are popular in the market. A lot of profits is reinvested into product research and development which helps in expansion.
Investing in growth stocks requires proper selection based on certain indicators. The secret to make profits is to construct your portfolio of good stocks and stay invested for a long period of time say 5 to 7 years. Here are some of the indicators which can be used to pick stocks:
Earning per Share (EPS)
EPS happens to be one of the most critical equity data for investors. It stands for net profit which the company has earned on every share. EPS impacts the market price of equity shares directly. It is calculated by dividing the profit after tax by total number of shares outstanding. EPS = Profit after tax (PAT) / No of shares outstanding.
If the profit after tax (PAT) earned by the company is Rs.10 Crore and the number of outstanding shares is 2 crore. It means that on each share the company earns Rs.5 (10/2). I believe, no other data influences stock price more directly than EPS. Any changes taking place in EPS are immediately visible in the market price of shares. A close relationship has been observed between EPS and market price of shares. An increase in EPS is accompanied by a rise in the stock price. Conversely, a fall in EPS results in falling of stock prices. Thus, EPS has become the most tracked financial parameter of companies.
Price Earning Ratio (P/E)
P/E ratio shows what price is the share able to fetch in the market as compared its earning per share (EPS). You may determine whether the share is perceived as valuable by the investors as its earnings depict. It is calculated by dividing the market price of the stock by the EPS. P/E = Market Price of the share / EPS.
If P/E is assumed to be constant, then a steady increase in EPS is going to increase the market price; which in turn shows higher demand for the particular share directly proportional. As EPS falls, the market price also starts falling in response. So in this way, growth stock try to maintain their P/E ratios to keep the market price at higher levels.
Growth in sales
Growth stocks strive hard to keep the sales momentum growing. The quantum of sales plays a crucial role to drive the overall growth of the organisation. An increase in sales leads to increase in the profitability of the company. A steady rise in profitability helps to boost the earning per share (EPS) which in turn increases the market price of share. A higher market price works well to boost the wealth of shareholders in the long run.
EPS of a company is highly dependent on its profitability. However, increasing profitability is not as simple as increasing sales. But still there’s one way to keep shareholders happy. A steady rise in sales growth would grow EPS faster. This would boost the market price leading to shareholder wealth maximisation.
A value stock is a security which trades at price that is lower than the fundamentals of the company like dividends, sales and earnings. Additionally, their stock price will be lower that the prices of stocks of other companies in the same industry.
The main aim of choosing value stocks is to take advantage of market inefficiencies. In such a situation, due to gaps in information, the market price of the underlying equity does not match the performance of the company. In spite of having a growth potential, these stocks remain undervalued and unnoticed by majority of investors.
Value stocks usually belong to mature companies which have a record of issuing stable dividends. This happens during periods when the company is experiencing negative events. These have a low price-earning ratio and above-average dividend yields. These stocks tend to deliver high performance during market slumps or when the market is at its initial stages of recovery.
Owing to skeptical tendencies of the market, value stocks seem to be riskier than growth stocks. To become a profitable proposition, perception of the entire market needs to change towards the company. Because of a higher underlying risk, value stocks are likely to be more profitable than the growth stocks in the long run. The real risk is when the idea of a value stock coming out of its undervalued position never materializes. Thus, while investing in value stocks your investment horizon assumes paramount significance.
You need to understand that growth and value investing are dynamic concepts. When you realise the intrinsic value in a value stock is realised, it doesn’t remain a value stock. Similarly, when price of a growth stock falls substantially, it loses the growth attribute but still retains a lot of value in it. You should know that none of the two styles offer guaranteed returns.
But this need not deter you from investing. You may choose funds which are based on blend style of investing; which picks both types of stocks. In this manner, you may reduce your likelihood of loss-making significantly.
While venturing into stocks, don’t blindly believe on anyone else’s advice. Conduct a thorough analysis before buying any stock. Do not invest more than 10% in any single company. Many a time investing in equity becomes complex.
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