Understanding equity style boxes

Roshan Pourghasemi

Abstract

The equity style box is a popular graphic that investors use to help visualize some of the characteristics of companies and the risks involved with them. On the horizontal axis, the style box shows whether a company is a value or a growth company, meaning a company that is seen as undervalued and a company that is seen to have a lot of potential for growth in the future, respectively. On the vertical axis is market capitalization, which is essentially how much a company is worth. Through understanding a style box, you can have a better grasp on the types of companies in the market and make better investment decisions.

An equity style box, as shown above, is a graphic investors use to show some of the main characteristics of a stock/fund. The style box is an important tool for investors to help visualize the risk-return of assets in their portfolio and how they fit into their future goals.

Key Takeaways

  • Equity style boxes are a nine square grid with the size of a company’s market capitalization on the vertical axis (from small to large) and type of stock (value vs. growth) on the horizontal axis

  • They allow investors to analyze market cap, type of stock, and other key features of a stock/fund

  • Larger companies tend to be safer but offer less potential returns, with smaller companies being the opposite

  • Value companies are companies that are deemed to be currently undervalued, while growth companies are companies that have a high potential for growth and large future returns

  • Investors can use boxes for research and decision making

Investment Style/Type of Stock - the Horizontal Axis

“Type of stock” is a pretty broad phrase, but, within the scope of this article, I will be using it to refer to whether a stock is a growth stock, value stock, or a mix of the two.

Value stocks are companies that are usually larger and well-established and are seen as being undervalued at the current market price. For example, if a company is currently being traded at $50, but an investor believes that the stock’s true value is $75, then they would consider that stock a value stock. One way investors gauge which stocks they think are undervalued is by looking at their price/earnings ratio. If a stock has a small price/earnings ratio, then the price of the stock is much smaller than its earnings relative to other stocks, which can make it be seen as undervalued. Because of this, value stocks typically have small price/earnings ratios. Typical industries that have many value stocks are banking and retail.

Growth stocks are companies that investors believe will outperform the market because of their future potential and are poised for market expansion in the coming years. This can be for many reasons, ranging from a new product coming soon to being seen as stronger than their competitors. Growth stocks typically don’t have large earnings, as investors buy shares with the company's future earnings in mind, making most growth stocks have high price/earnings ratios. Typical industries that have many growth stocks are tech and healthcare.

A mix of the two would be a stock that is seen to be undervalued but also has the potential to grow beyond what the stock’s true value is.

If you are trying to identify whether a stock is a growth or a value stock, ask yourself these questions:

If you answered yes to these questions, that company can be considered to be that type of stock.

Market Capitalization - the Vertical Axis

Whenever you hear someone say that, “x company is valued at x dollars,” they are referring to that company’s market capitalization (cap). Market cap is the value of a company, and it is calculated by taking the current stock price and multiplying it by the number of shares. For example, as of writing this article, Amazon (AMZN) has a stock price of $137.28 and there are currently 10,174,409,620 shares of Amazon, making its market cap a whopping 1.4 trillion dollars.

While it's not exactly defined, a market cap of over $10 billion qualifies a business as a large company, and a market cap of $250 million - $2 billion would generally qualify a business as a small company.

In theory, larger companies are seen as safer investments, as they are better established and have a history of success. They also tend to pay out dividends, payments the company gives shareholders to share the profits. However, larger companies have much less potential for growth. Small companies, on the other hand, are seen as more volatile, they tend not to give dividends, and they are seen as having a high potential for growth.

Many large companies give dividends, in turn making them safer investments. This begs the question, “why do companies give them out in the first place?” Simply put, the companies want to share their profits with their investors, and dividends are a way for companies to entice investors to stick around. The amount of a dividend and whether a company will even distribute dividends is generally finalized on a quarterly basis. Companies will also give a record date, the date by which you have to be a shareholder in order to receive a dividend. This article goes a little more into the nuances of how dividends are paid out.

Another important metric in regards to dividends is the payout ratio, which is calculated by the dividends per share divided by the earnings per share. For example, if company A made $1,000,000 in profit, has 1,000,000 shares, and announced they are giving out $0.50 in dividends per share, then their payout ratio would be 50%, as the earnings per share (profit divided by shares) is $1 and the dividends per share is $0.50.

Since companies are giving back a portion of their earnings to shareholders, they lose out on potential capital to reinvest back into the business. This is why growth companies generally don’t give dividends, as they want to reinvest quickly back into their business and grow at a quick rate. Value companies do give back dividends, however, because they are already well-established and can afford to use it as an incentive to shareholders. Since value companies give back dividends, which are guaranteed money for the investor, this makes them much safer than growth stocks. As larger companies are safer investments than smaller ones, when you go down or to the right on an equity style box, the risk of an investment will increase.

This example style box will give some examples of companies that fit into each spot:

The End Goal

For most of us, the goal of investing is to maximize our returns and minimize our risks. One of the most common ways to achieve this is diversification. You can diversify your portfolio by investing in both value and growth companies, as the pros of one can offset the cons of another.

Going all in on one type of stock is a bit like gambling, where, if you get lucky, you can either make a quick sum of cash or dodge a quick drop in the value of a stock. Good investors, however, will diversify their portfolio so as to leave less up to chance. For example, if an event shifted the market and lowered many stock prices, larger and value companies would be more resilient to the shift in conditions. If you had diversified, then your portfolio would not drop as much as if you had gone all in on growth stocks.

Sometimes, though, we want to look at our individual assets instead of our whole portfolio and see how they are doing. A good metric to judge an asset is its total return, calculated by considering the interest, capital gains, dividends, and distributions realized over a period of time, typically a year. It is usually expressed as a percentage of the amount invested. This metric is used since capital gains will not always give an accurate return.

For example, capital gains will tell you that a value stock that didn’t grow much may be considered a bad investment. If you take into account the dividends it paid though, it could be a whole different story. In the end, when comparing two stocks, you should use the total return as the comparison, as it paints a clearer picture.

This table shows an example of the merit of looking at total return:

As you can see above, company A returned more money to the investor, but that wouldn’t have been seen if the investor only looked at the capital gains.