The stock of a wonderful firm with superior management and strong performance measured by sales and earnings growth can be priced so high that the intrinsic value of the stock is below its current market price and should not be acquired. In contrast, the stock of a company with less success based on its sales and earnings growth may have a stock market price that is below its intrinsic value.
Growth Companies and Growth Stocks
Observers have historically defined growth companies as those that consistently experience above-average increases in sales and earnings. This definition has some limitations because many firms could qualify due to certain accounting procedures, mergers, or ocher external events. In contrast, financial experts define a growth company as a firm with the management ability and the opportunities to make investments that yield rates of return greater than the firm’s required rate of return.
Growth stocks are not necessarily shares in growth companies. A growth stock is a stock with a higher rate of return than other stocks in the market with similar risk characteristics. The stock achieves this superior risk-adjusted rate of return because at some point in time the market undervalued it compared to other stocks. Although the stock market adjusts stock prices relatively quickly and accurately to reflect new information, available information is not always perfect or complete. Therefore, imperfect or incomplete information may cause a given stock to be undervalued or overvalued at a point in time.
If the stock is undervalued, its price should eventually increase to reflect its true fundamental value when the correct.information becomes available. During this period of price adjustment, the stock’s realized return will exceed the required return for a stock with its risk, and, during this period of adjustment, it will be considered a growth stock. Growth stocks are not necessarily limited to growth companies. A future growth stock can be the stock of any type of company; the stock need y be undervalued by the market.
Defensive Companies and Stocks
Defensive companies are those whose future earnings are likely to withstand an economic downturn. One would expect them to have relatively low business risk and not excessive financial risk. Typical examples arc public utilities or grocery chains-firms that supply basic consumer necessities.
There are two closely related concepts of a defensive stock. First, a defensive stock’s rate of return is not expected to decline during an overall market decline, Second, A stock with low or negative systematic risk may be considered a defensive stock.
Cyclical Companies and Stocks
A cyclical company’s sales and earnings will be heavily influenced by aggregate business activity. Examples would be firms in the steel, auto, or heavy machinery industries. Such companies will do well during economic expansions and poorly during economic contractions. This volatility of return is typically a function of the firm’s business and can be compounded by financial risk.
A cyclical stock will experience changes in its rates of return greater than changes in overall market rates of return, The stock of a cyclical company, however, is not necessarily cyclical. A cyclical stock of any company that has returns that are more volatile than the overall market.
Speculative Companies and Stocks
A speculative company is one whose assets involve great risk but that also has a possibility of great gain. A good example of a speculative firm is one involved in oil exploration.
A speculative stock possesses a high probability of low or negative rates of return and a low probability of normal or high rates of return. Specifically, a speculative stock is one that is overpriced, leading to a high probability that during the future period when the market adjusts the stock price to its true value, it will experience either low or possibly negative rates of return.