A Deeper Dive into the Value Factor


The third risk factor in the Fama/French model is the amount of exposure to low priced stocks, which is measured by a book-to-market (BtM) value ratio. The book value of a company is just an accounting term for its net worth, its assets minus its liabilities. The market value of a company is its price per share times the number of shares outstanding. This risk factor is known by several different designations. It has been referred to as the value factor, BtM factor, style factor and price factor. Note that charts referring to it may have any of these designations. The most current designation is the price factor, referring to the low prices of these stocks compared to a company’s book value or to other stocks.

Exposure to the price factor is determined by the amount of a portfolio exposure to high BtM stocks. In other words, when a stock’s market price is less than its book value, the BtM ratio is greater than one. The greater the exposure to the price factor, the higher the historic and expected return in comparison to low BtM stocks. High BtM companies usually have low earnings and experience other signs of financial distress. Investors don’t like these stocks for these reasons. As a result of their poor track records, the market drives down the prices of these stocks. This naturally makes them riskier to investors.

Stocks with a low BtM ratio have low book values relative to their market prices and are termed growth stocks. Investors favor growth stocks because they’re perceived to be great companies and therefore are less risky. They often represent successful companies with strong track records and healthy earnings. They can also represent companies that have had no earnings but offer a product or service that is deemed to have a high potential for future growth.

The Nobel Prize-winning contribution made by Merton Miller provides a framework for better understanding the connection between the price risk factor and stock returns. Miller set forth a simple but profound notion: the cost of capital to a company equals the expected return to an investor who holds its stock. A company’s cost of capital is reflected by the price and book value of its shares or the amount that investors are willing to pay to receive a dollar of book value (a higher share price implies a lower cost of capital). The Figure below proves out Miller’s Nobel-prize winning research. The figure plots the long-term risk and return characteristics for the entire U.S. stock market as divided by book-to-market ratios in five quintiles. As you can clearly see, the low-book-to-market companies (numbers 1 and 2) produced lower returns that came with a lower risk. The 20% of all U.S. companies with the highest book-to-market (number 5) were perceived to be in the greatest distress, and consequently paid a higher cost of capital (return) to their investors.

For an explanation of Book Value versus Market Value, watch this video from the Khan Academy.

Suppose that a value company and a growth company each approach a bank for a loan. Which company will have to pay the higher cost of capital (the higher interest rate) on its loan? The value company will pay the higher cost because its future is less certain and the bank will need to charge extra interest for taking the extra risk that the company won’t be able to pay back its loan. Thus, the riskier the company’s stock, the higher the cost of capital paid by a company.

Because the market perceives a value stock to be riskier, it drives down their price so that the expected return is high enough to make it worthwhile for investors to hold, despite the extra risk they take when buying it. In this way, stock prices adjust, (the market sets the price at a discount, so its expected return is higher) to reflect the perceived riskiness of the stock. This ensures that the stock will be purchased, even though growth companies have better earnings prospects and generally seem safer.

The key to understanding the connection between the price risk factor and stock returns lies in focusing on the market price of a stock. A high BtM ratio suggests that the market values the stock less than the stock’s accountants. This is usually because the stock has poor earnings as well as other indications of financial distress. This makes the stock riskier. As a result, investors demand a higher rate of return to compensate them for the risk that a high BtM stock will do worse than expected, go bankrupt, and end up as one of the “stocks in a box.”

A 1987 study compared the investment performance of a portfolio of 29 growth stocks to one with 29 value stocks. The growth stocks represented companies that were stronger and healthier than value stocks by every economic measure, including return on total capital, return on equity, and return on sales. The value stocks represented companies that had little profitability, terrible management, and a bad image. Yet, the study found that the value stocks outperformed the growth stocks, 298% to 182%, over the five-year period of 1981 to 1985.

This means that investors earned higher returns by owning the stocks of companies that did poorly. That seems counterintuitive to most investors, since they tend to think that healthy stocks are better investments than distressed stocks. After all, if investors ask for a stock tip, they want to hear the name of the next Microsoft, not a stock with poor earnings. The fact is that investors should be interested in great investments (value stocks), not great companies (growth stocks).