Swedroe: A More Complex View On Value

March 29, 2017

Eugene Fama and Kenneth French’s 1992 paper, “The Cross-Section of Expected Stock Returns,” resulted in the development of the Fama–French three-factor model. This model added the size and value factors to the market beta factor.

As my co-author, Andrew Berkin, and I demonstrate in “Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today,” the value premium has been persistent across long periods of time and different economic regions, and pervasive across the globe and even asset classes (cheap assets have outperformed expensive assets).

And while the most common metric used to define value has been the book-to-market (BtM) ratio (as in Fama and French), it has been robust in other definitions. For example, in the United States for the period 1952 through 2015, the annualized value premium was 4.1% (t-stat = 2.4) as measured by BtM, 4.7% (t-stat = 2.9) as measured by the cash flow-to-price ratio, and 6.3% (t-stat = 3.4) as measured by the earnings-to-price ratio.

Measuring Value
Ray Ball, Joseph Gerakos, Juhani T. Linnainmaa and Valeri Nikolaev contribute to the literature on the value premium in their February 2017 paper, “Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns.” Their study, using Center for Research in Security Prices and Compustat data, covers the period July 1963 through December 2015. The sample excluded the bottom 20% of stocks (microcap stocks) as ranked by NYSE market capitalizations, as well as financials.

Note that excluding these financials is typical in academic papers. Omitting the smallest stocks is done so that these stocks don’t dominate results—they make up more than half the number of stocks but have much less market-cap weight. It’s also important to note that, typically, one sees stronger results for factors in these smaller-cap stocks. For example, using BtM, the value premium is much larger in small stocks than in large stocks.

Ball, Gerakos, Linnainmaa and Nikolaev begin by noting that book value of equity consists of two main parts: retained earnings (earnings less dividends) and contributed capital (the value of subsequent net share issuance). Following is a summary of their findings:


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