The stock market is crucial to the economic performance of a country. Apart from being a source of business capital, investment, and government funds, stock markets play a role in personal wealth too. Stock market investments not only act as a source of income and retirement savings but also help beat inflation of the country. The figure below summarises the different advantages of stock market investment for the economy and investors.
However, apart from these advantages, stock market investment suffers from shortcomings. Due to the availability of different stocks and companies, investors face difficulty in identifying the right stock to invest in (Green, 2015; Mishra, 2018; Shah, Isah, & Zulkernine, 2019). The previous article summarised three main types of stocks:
- growth and,
The aim of this article is to review the parameters using which stocks are classified into these categories.
The rationale behind the categorization of stocks
The choice of the optimal stock depends on an investor’s tolerance for risk and their future needs. A risk-averse investor who is sensitive to stock market volatility prefers to opt for a safe source of income by choosing income stocks. However, an investor who wants to earn more at the cost of higher risk prefers to invest in growth stocks. Growth stocks do not pay high dividends and are highly sensitive to market fluctuations and financial downturns. But the possibility of high capital gain appeals to some investors. Lastly, value stocks are for investors expecting long-term returns with less risk. Thus, value stocks investors opt for companies that are undervalued but have a tremendous potential to grow (Thune, 2020; Treadwell, 2018).
Differentiation of stocks into income, growth and value categories
There are many studies elaborating methods to classify stocks. Akinde, Peter, & Ikpefan, (2019) stated that financial measures like price to earnings ratio, earning per share, return on assets, capital gain, dividend yield, and opportunity cost helps in identifying the nature of stock. Cordeiro & Machado, (2013) empirically analyzed the Brazil stock exchange and stated that the most common ratios which differentiate between growth and value stocks are book to market, price to cash flow, and price to earnings. Therefore the variables which help in categorizing the stocks into income, growth and value stocks are:
- Price to earnings ratio
- Price to book value ratio
- Dividend yield ratio
Income stocks are ones which regularly yield dividend and can even grow in the yield after adjusting dividend for inflation (Groww, 2020). Income stocks are less volatile as compared to other stocks in the market and even provide the highest yield compared to average market yield (Chen, 2019). Thus, stocks with a low beta value (less than 1) and high dividend yield are income stocks. Lower the beta value of the stock, the lesser the risk of volatility (Caplinger, 2019). Further, income stocks are assets that provide the highest yield rate (3-6%) to investors.
Companies raising growth stocks aim to generate growth opportunities for the future through expansion. Hence, growth stocks have a higher price to earnings ratio (greater than 20) than the average rate in the market. Stoddard, (2013) stated that the threshold value of price to earnings ratio for categorizing a stock as a growth stock is 20. There are more chances of capital gain for companies with growth stocks.
Compared to growth stocks, value stocks are issued by undervalued companies. Thus, their main purpose is not to grow but to gain a stronghold in the market. Therefore, the price to earnings ratio of value stocks is less than 15 (Beneda, 2002). Moreover, their price to book value ratio is less than 1.5. Hence, stocks having a price to earnings ratio of less than or equal to 15 along with a price to book value ratio of less than or equal to 1.5 are labeled as value stocks.
The table below summarises these key differences between the three types of stocks.
|Income Stocks||Beta ≤ 1 and Dividend yield between 3-6%|
|Growth Stocks||P/E ≥ 20|
|Value Stocks||P/E ≤ 15 and P/B ≤ 1.5|
- Akinde, M. A., Peter, E., & Ikpefan, O. A. (2019). Growth versus value investing: A case of Nigerian stock market. Investment Management and Financial Innovations, 16(1), 30–45. https://doi.org/10.21511/imfi.16(1).2019.03
- Beneda, N. (2002). Growth stocks outperform value stocks over the long term. Journal of Asset Management, 3(2), 112–123. https://doi.org/10.1057/palgrave.jam.2240070
- Caplinger, D. (2019). A Beginner’s Guide to Income Investing.
- Chen, J. (2019). Income Stock.
- Cordeiro, R. A., & Machado, M. A. V. (2013). Value or Growth Strategy? Empirical Evidence in Brazil. Review of Business Management, 15(46), 91–111. https://doi.org/10.7819/rbgn.v15i46.1170
- Green, A. (2015). Importance of the Stock Market to the Economy.
- Groww. (2020). What are Income Stocks?
- Krakow, I. (2007, October). Value Stock-Picking, Week 2: How to Pick Bargain Stocks. The Street.
- Mishra, M. (2018). Importance of stock market in the economy.
- Nathan, N., Singh, S. K., & Dhanorkar, S. (2015, May). Learn how to pick value stocks. Economic Times.
- Shah, D., Isah, H., & Zulkernine, F. (2019). Stock market analysis: A review and taxonomy of prediction techniques. International Journal of Financial Studies, 7(2). https://doi.org/10.3390/ijfs7020026
- Stoddard, S. (2013, April). Ignore P-E Ratios When Evaluating High-Growth Stocks. Investor’s Business Daily.
- Thune, K. (2020). Dave Ramsey Growth and Income Funds. Retrieved April 3, 2020, from https://www.thebalance.com/hey-dave-ramsey-what-is-growth-and-income-3972910
- Treadwell, L. (2018). 7 Categories to Classify Stocks.
- An overview of the annual average returns and market returns (2000-2005) - October 22, 2020
- Introduction to the Autoregressive Integrated Moving Average (ARIMA) model - September 29, 2020
- Risk tolerance by stocks categorization using ratio analysis - September 10, 2020