Advanced Diploma of Financial Planning (ADFP) Practice Test

How are stocks referred to when they are priced high relative to historical earnings and current asset value?

1. Blue-chip stocks

2. Value stocks

3. Growth stocks

4. Penny stocks

The correct answer is: Value stocks

The correct answer is growth stocks. These stocks are characterized by their higher price-to-earnings (P/E) ratios compared to the broader market, often because investors expect significant earnings growth in the future. They are typically priced high relative to historical earnings because the market anticipates that the company will continue to grow at a faster rate than its competitors or the overall market. Growth stocks are often associated with companies in emerging industries or those that are innovating, leading to rapid expansion. Consequently, this expectation of future performance justifies their elevated price tags, even if their current earnings do not fully reflect their potential. Investors are willing to pay a premium for these stocks in hopes of substantial growth over time. This contrasts with value stocks, which tend to be priced lower relative to their earnings and book value, reflecting a different investment strategy focused on undervalued companies. The other choices represent different categories of stocks that do not inherently describe stocks priced high relative to earnings. Blue-chip stocks are well-established companies with a history of stable earnings but may not fit the high valuation characteristic described. Penny stocks are low-priced stocks, often under $5, which usually carry higher risks and are not associated with high relative valuations. Understanding these distinctions helps investors make more informed decisions