Why Investors Buy Stocks

Investors usually purchase stocks for two main reasons: they expect the price to rise, allowing them to sell at a profit, or they seek to collect dividends as income. While some stocks may offer both benefits to some extent, most can be categorized into one of three types: growth, income, or value. Understanding these categories helps investors make better decisions and grow their portfolios more effectively.

Growth Stocks

As the term implies, growth companies focus on significant, often rapid, growth compared to the overall market. These companies reinvest their revenues into further expansion, positioning themselves as high-potential investments across various sectors, particularly in technology, alternative energy, and biotechnology.

Growth stocks typically come from newer companies offering innovative products that could greatly influence the market. However, established companies with strong business models that respond to market demand can also be classified as growth stocks. While these stocks can deliver impressive returns, they often come from smaller, less stable companies that might face significant price fluctuations.

Example of a growth stock: Amazon.com Inc. (AMZN) – A leading player in the online retail space, Amazon continues to innovate and expand into new markets. As of October 22, 2021, its trailing P/E ratio of 58 underscores its considerable growth potential compared to the S&P 500’s trailing P/E ratio of 26.9.

Value Stocks

Value stocks are undervalued shares that may offer long-term profits if properly researched. ‘Undervalued’ means the stock is trading below its intrinsic value based on financial or technical indicators. Value stocks often have high dividend payouts or low financial ratios like price-to-book or price-earnings ratios. Sometimes, stock prices decline due to factors unrelated to the company’s actual performance.

For example, a financially sound company’s stock might drop temporarily due to a public scandal involving its CEO. Savvy investors may see this as a buying opportunity, anticipating that the stock will recover once the public moves past the incident.

The concept of value can be subjective and vary according to an investor’s perspective. Generally, value stocks are considered less risky than growth stocks because they are often from larger, more established companies. However, there is no guarantee that the stock price will return to its previous high levels.

Income Stocks

Investors look for income stocks for their stability and higher dividend yields compared to guaranteed income instruments like Treasury bonds or certificates of deposit (CDs).

There are two primary types of income stocks:

• Utility Stocks: Common stocks that usually maintain stable prices while providing consistent dividends.
• Preferred Stocks: Hybrid securities that function more like bonds, often including call or put features, but also offer competitive yields.

While income stocks are appealing for investors seeking to preserve their principal, their values may decrease if interest rates rise.

Example of an income stock: AT&T (T) – A financially robust company with a manageable debt load, AT&T paid an annual dividend yield of 8.16% as of October 22, 2021.

How to Identify Stocks in These Categories

There’s no universal method for identifying growth, income, or value stocks. Investors interested in growth stocks can look at investing websites or forums for lists of such companies and conduct thorough research. Financial analysts also publish blogs or newsletters featuring stocks in these categories.

For income stocks, investors can calculate dividend yields on common and preferred stocks, assessing each security’s risk level. Stock screening tools are available to help investors search for stocks based on specific criteria, such as dividend yield or financial ratios.

The Bottom Line

Stocks offer different types of returns: potential future growth, current undervaluation, or dividend income. Many stocks, such as AT&T, provide a combination of these features. Savvy investors understand that dividends can significantly enhance the total return on their investments. Identifying the right type of stock for your goals is crucial for building a successful portfolio.