Value vs Growth
People often wonder why some companies are priced at a higher P/E while others are priced at a lower P/E. While there could be several reasons for the same, it is usually a question of the market’s expectations for growth in the company’s profits.
A company that is expected to grow a lot in the years ahead is constantly trading at a higher P / E than a company with lower growth prospects, all other things being equal. Remember that today’s earnings per share are not really relevant.
It is what the company earns in the future that is interesting and what shares are priced at. Therefore, a company with a high P / E today can be cheap if you expect strong growth. Opposite, a low P/E today might not be so cheap if the future profit declines.
There are several indices that are divided into value or growth in the US. There is an index called Russel 1000 Growth, which is also traded as an ETF (exchange-traded fund) with ticker code IMF. The index includes equities that are expected to have a growth rate higher than the market average. Here are some data as of March 1, 2020:
| Average P / E | 23,4 |
| Average P / B | 5,69 |
| Standard deviation | 11,19% |
| Beta | 1,06 |
Another value index called Russel 1000 Value is available as ETF with ticker code IWD. This has the following values as of 1 March 2020:
| Average P / E | 18,98 |
| Average P / B | 2,01 |
| Standard deviation | 10,62% |
| Beta | 1,00 |
As expected, P / E and P / B are much lower in the value shares.
But how are the returns of the two different types of stocks?
Research shows that there is a value premium: Value stocks show better returns than growth stocks (in the long run).
Fidelity, an American money manager, looked at the returns between value and growth from 1990 until 2015:
|
US largecap growth |
US largecap value |
US midcap growth |
US midcap value |
US smallcap growth |
US smallcap value |
|
|
26-year returns |
8.6% |
9.03% |
9.72% |
10.49% |
8.32% |
10.19% |
|
26-year standard deviations |
21.42% |
16.67% |
24.61% |
17.9% |
23.42% |
18.97% |
|
Growth of 10 000 invested |
85 435 |
94 694 |
111 584 |
133 660 |
79 878 |
124 669 |
Value stocks have returned better and at the same time showed less variability in the returns. This means that the risk-adjusted return is much better than growth stocks. If there is a recession, you can expect value stocks to fall less in price than growth stocks.