Warren Buffett: Forget About Value vs. Growth Investing

By Markets Fool.com

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Wall Street analysts and the financial media typically use the terms "value" investing and "growth" investing as opposing ideas. However, Warren Buffett believes this way of thinking is too myopic and can lead to some important misconceptions when evaluating investment opportunities.

So what is the Oracle of Omaha suggesting exactly?

Value and growth are joined at the hip
Value investing is about buying a company for a market price below the intrinsic value of the business. According to Buffett, this is the only way to truly invest, since paying a price above the estimated value -- usually hoping to sell it for an even higher price -- should be considered speculation.

Growth is one of the variables you need to consider when estimating that intrinsic value. Growth can be a major part of the company's value, or it can be a less crucial driver -- it depends on the particular business. Growth can also sometimes be negative in terms of value -- this happens when a company puts money to work in ultimately unprofitable growth initiatives. In his letter to Berkshire Hathaway shareholders in 1992, Buffett wrote:

Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

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Companies trading at relatively low valuation ratios are usually referred to as value stocks, while those with superior growth rates and higher than average valuations are generally called growth stocks. But Warren Buffett believes these simplifications are severely lacking, as growth and value are intimately related. Elaborating on this concept, Buffett wrote to his shareholders in 2000:

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation, except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component - usually a plus, sometimes a minus - in the value equation.

How to think about value and growth
Trying to pigeonhole companies as growth or value stocks based on a particular metric can be quite confusing, and Apple is a clear example of this.

Apple reported a mind-blowing year-over-year increase in earnings per share of 48% during the last quarter, way above the performance you can find in most other companies in the market. In addition to benefiting from booming iPhone 6 and iPhone 6 Plus sales, Apple is innovating in new businesses with Apple Watch and Apple Pay. Considering both financial performance and innovative drive, Apple would clearly fall in the growth category.

On the other hand, Apple trades at a forward P/E ratio of 12.8 times, a significant discount to the 17.4 times for companies in the S&P 500. When looking at valuation ratios, Apple looks like a value stock in the traditional sense of the word.

One way of interpreting this dichotomy: The market assigns a lower valuation to Apple, because investors have concerns about the its ability to sustain growth. Apple just reported the largest quarterly profit in history for a publicly traded company, and growth tends to slow down as a company becomes larger over time. Besides, nearly 69% of total revenues came from the iPhone segment in the last quarter, so product concentration is a significant risk.

I personally believe the market is overestimating these risks, as Apple has the brand differentiation, human talent, and competitive strength to continue delivering substantial growth in the years ahead. For this reason, Apple looks like an attractive investment to me, and I am planning to hold my Apple stock for the long haul.

Conversely, those who think Apple will be facing stagnant and even declining sales over the coming years probably believe the company is overvalued, no matter what valuation ratios or recent financial performance indicate.

Forget about value vs. growth investing. The intrinsic value of a business depends on multiple variables, among them, future growth rates. Instead of making a short-sighted differentiation between two "categories" of stocks, investors should incorporate growth expectations into that intrinsic value, making a purchase decision when estimated value is sufficiently above market price. No need to take my word for it, the Oracle of Omaha agrees.

The article Warren Buffett: Forget About Value vs. Growth Investing originally appeared on Fool.com.

Andrs Cardenal owns shares of Apple and Berkshire Hathaway.The Motley Fool recommends Apple and Berkshire Hathaway. The Motley Fool owns shares of Apple and Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.