The Anatomy of Value and Growth Stock Returns

Average returns on value and growth portfolios are broken into dividends and three sources of capital gain: (1) growth in book equity, primarily from earnings retention, (2) convergence in price-to-book ratios (P/Bs) from mean reversion in profitability and expected returns, and (3) upward drift in P/B during 1927–2006. The capital gains of value stocks trace mostly to convergence: P/B rises as some value companies become more profitable and their stocks move to lower-expected-return groups. Growth in book equity is trivial to negative for value portfolios but is a large positive factor in the capital gains of growth stocks. For growth stocks, convergence is negative: P/B falls because growth companies do not always remain highly profitable with low expected stock returns. Relative to convergence, drift is a minor factor in average returns.Value stocks (with low ratios of price-to-book value) have higher average returns than growth stocks (with high P/Bs). To better understand this value premium, we break average returns on value and growth portfolios in the 1926–2006 period into dividends and three sources of capital gain: (1) growth in book equity, primarily from earnings retention; (2) convergence in P/Bs as a result of mean reversion in profitability and expected returns; and (3) upward drift in P/Bs.The contribution of dividends to average returns is higher for value stocks than for growth stocks for our second subperiod, 1964–2006. But the higher dividends of value stocks are special to this period. For the earlier subperiod, 1927–1963, the contribution of dividends to average returns is similar for value and growth stocks.Differences in the way capital gains split between growth in book equity and growth in P/B are more consistent for the full sample period than the patterns in dividends. In the year after companies are allocated to value portfolios, they do not do much equity-financed investment and growth in book equity is, on average, minor. Thus, the large average capital gains of value stocks show up as increases in P/B. In contrast, companies invest heavily after they are allocated to growth portfolios, and the growth rate of book equity, on average, exceeds the growth rate of the stock price. Thus, P/B, on average, declines after companies are identified as growth stocks, and the positive average rates of capital gain of growth portfolios trace to increases in book equity that more than offset declines in P/B.We look to standard economic forces to explain the behavior of P/Bs after stocks are characterized as value or growth. When companies are allocated to value and growth portfolios, they tend to be at opposite ends of the profitability spectrum. Growth companies tend to be highly profitable and fast growing, whereas value companies are less profitable and they grow less rapidly, if at all. For growth stocks, high expected profitability and growth combine with low expected stock returns (low costs of equity capital) to produce high P/Bs, whereas for value stocks, low profitability, slow growth, and high expected returns produce low P/Bs.Competition from other companies, however, tends to erode the high profitability of growth stocks, and profitability also declines as these companies exercise their most profitable growth options. Thus, each year, some growth stocks cease to be highly profitable, fast-growing companies that are rewarded by the market with low costs of equity capital (expected stock returns). As a result, the P/Bs of growth portfolios tend to fall in the years after portfolio formation. Conversely, the P/Bs of value portfolios tend to rise in the years after portfolio formation as some value companies restructure, improve in profitability, and are rewarded by the market with lower costs of equity capital and higher stock prices.The tendency of P/Bs to become less extreme after companies are placed in value and growth portfolios is what we call “convergence.” There has also been a general upward drift in P/Bs, however, in the 1927–2006 period. Higher prices relative to book values imply some combination of higher expected cash flows and lower expected stock returns (discount rates for expected cash flows) at the end of the period than at the beginning. We label this the “drift effect” in P/B and average returns.The total increase in P/Bs for the sample period is large, but the contribution of this drift to average returns is modest relative to the contribution of convergence. The differences between average growth rates of P/Bs for value and growth portfolios are thus mostly a result of convergence.