Growth Versus Value Investing
Equity styles split the market into growth and value. Growth stocks trade at high multiples because investors expect rapid future earnings growth, while value stocks trade at low multiples relative to fundamentals such as earnings or book value. Style is defined mainly by multiples, the price-to-earnings (P/E) and price-to-book (P/B) ratios being the standard cut. The historical tendency for value stocks to outearn growth stocks on average is the value premium, documented by Fama and French and folded into multifactor asset-pricing models. Whether the premium is risk-based compensation or a behavioral mispricing remains debated.
Why it matters
Two companies can earn the same profit yet sell for very different prices. The market pays up for a glamorous grower it believes will earn much more soon, and pays little for a dull, cheap firm it doubts. Sorting on a multiple like price-to-book separates the two camps. History says the cheap value bucket has tended to beat the expensive growth bucket on average, the value premium. The argument is whether that extra return rewards bearing more risk or simply corrects an over-optimistic crowd that priced growth too dearly.
Formulas
Worked examples
Firm A trades at a P/E of 35 and a P/B of 8. Firm B trades at a P/E of 9 and a P/B of 1.1. Classify each by style.
Firm A carries high multiples, so the market is pricing in rapid future growth, making it a growth stock. Firm B carries low multiples relative to its earnings and book value, the signature of a value stock. The value premium is the historical observation that, on average across many such pairs, the low-multiple value names have outearned the high-multiple growth names, though not in every period.
Common mistakes
- ✗Value stocks are simply cheap because they are bad companies. Low multiples can reflect genuine risk or temporary pessimism rather than a doomed business. The value premium is the historical reward, on average, for holding the low-multiple basket.
- ✗Growth investing always beats value because growth firms grow faster. Faster earnings growth is already embedded in the high price you pay. The relevant question is the return per dollar invested, where the value basket has historically held an edge on average.
- ✗The value premium is guaranteed in every period. It is a long-run average, not a constant. Growth can dominate value for years at a time, as in some recent stretches, so the premium is a tendency rather than a sure thing.
- ✗Growth and value are about the company’s growth rate alone. Style is defined by valuation multiples relative to fundamentals, not the raw growth rate. A fast grower priced cheaply could screen as value, and a slow grower priced richly could screen as growth.
Revision bullets
- •Growth stocks trade at high multiples on expected earnings growth
- •Value stocks trade at low multiples relative to fundamentals
- •Style is defined mainly by multiples such as P/E and P/B
- •The value premium is the historical average outperformance of value over growth
- •Fama and French sort on book-to-market and add the value factor to asset pricing
- •Whether the premium is risk-based or behavioral remains debated
Quick check
A stock with a very high P/E and high P/B relative to its peers is best classified as a
The value premium refers to the historical tendency for
Connected topics
Sources
- Brailsford, Heaney & Bilson (2015), Ch. 13Brailsford, T., Heaney, R., & Bilson, C. Investments: Concepts and Applications. 5th ed. Cengage Learning Australia, 2015.Defines growth and value styles, the multiples that separate them, and the value premium.
- Bodie, Kane & Marcus (2021), Ch. 13Bodie, Z., Kane, A., & Marcus, A. J. Investments. 12th ed. McGraw-Hill Education, 2021.Reference for the Fama-French factors, book-to-market sorting, and the risk-versus-behavioral debate.