Types of Stocks

59.a. differentiate between 1) a growth company and a growth stock, 2) a defensive
company and a defensive stock, 3) a cyclical company and a cyclical stock,
4) a speculative company and a speculative stock, and 5) a value stock and a
growth stock;




Company Analysis and Stock Valuation

By evaluating financial performance variable we can identify good companies. But good companies are not necessarily good investments. For finding a good investment, we have to compare the intrinsic value of a stock to its market value.

Stock of a great company may be overpriced and in such as a case the stock of a growth company may not be growth stock.

Growth Companies

Growth companies have historically been defined as companies that consistently experience above-average increases in sales and earnings. Financial theorists define in more specific terms a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return. So in the definition of financial theorists growth company has a return on investment that is greater than the required rate of return based on its risk measure.

Growth Stocks

Growth stocks are not necessarily shares in growth companies.

A growth stock has a higher rate of return than other stocks with similar risk. Growth stocks give a higher return in comparison to the risk adjusted return that is expected from stocks with similar risk measure.

Superior risk-adjusted rate of return occurs because in the market they are undervalued at that point of time compared to other stocks

Defensive Companies and Stocks

Defensive companies’ future earnings are more likely to withstand an economic downturn. They have low business risk and not excessive financial risk

Defensive stocks are stocks with low or negative systematic risk (beta values). While defensive companies' stocks can be defensive stocks, they are defensive stocks only when their beta value is significantly less than one. So the analyst have to calculate beta value of a stock before declaring any stock as defensive stock.

Cyclical Companies and Stocks

Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business activity.

Cyclical stocks are those that will experience changes in their rates of return greater than changes in overall market rates of return. In this case beta value of stocks are significantly higher than one.

Speculative Companies and Stocks

Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain.

Speculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return. When markets are at historical peaks or stocks are way above their intrinsic values, many stocks may become speculative.


Value versus Growth Investing

In the debate about growth and value investing, both growth and value stocks are have higher risk adjusted returns compared to other stocks.

IN this context, growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued relative the growth of earnings and dividends expected from them.

Value stocks appear to be undervalued for reasons besides earnings growth potential. The growth potential in earnings and dividends is not spectacular in these stocks, and the undervaluation will be because of apprehension that the sales and earnings may decline relative to average companies.

On the basis of quantitative criteria, value stocks (population or all the companies from value stocks are identified) usually have low P/E ratio or low ratios of price to book value. Growth stocks (population or all the companies from which growth stocks are identified) usually have high P/E ratios and high price to book value ratios.