Is the value premium so fundamental that its exists generally among stock markets? In their recent paper entitled “Value versus Growth: Australian Evidence”, Philip Gharghori, Sebastian Stryjkowski and Madhu Veeraraghavan test the abilities of indicators based on several alternative definitions of “value” to explain the cross-sectional variation in stock returns in Australia. Specifically, they test book-to-market value ratio (B/M), sales-to-price ratio (S/P), cash flow-to-price ratio (C/P) and earnings-to-price ratio (E/P). They also compare the predictive powers of these value indicators to those of size and debt-to-equity ratio (D/E). Using firm financial data for 1/92-12/04 and associated monthly stock prices for 1/93-12/04 (a total of 137,139 firm-month observations), they find that:
- There is a strong positive relationship between B/M and future stock returns, with an average 2.79% difference in monthly returns between the tenth of stocks with highest B/M and the tenth with the lowest. (See the first table below.) B/M is the only value indicator that retains strong predictive power after controlling for all the other indicators.
- S/P also relates positively to future returns, with an average 2.23% difference in monthly returns between the tenth of stocks with highest S/P and the tenth with the lowest.
- For firms with positive (negative) E/P and C/P, both relate positively (negatively) to future stock returns. (See the second table below.) E/P and C/P are highly correlated.
- D/E relates positively to future returns, with an average 1.36% difference in monthly returns between the tenth of stocks with highest D/E and the tenth with the lowest. The relationship is, however, non-linear.
- Firm size relates negatively to future returns, with an average 5.68% difference in monthly returns between tenth of stocks with the smallest market capitalizations and the tenth with the largest. The relationship is, however, non-linear and is concentrated in the smallest 20% of stocks.
The following tables, taken from the paper, show average monthly returns (in percent) on equally-weighted portfolios formed by ranking the indicators monthly over the period 1/93-12/04.
The first table reports average monthly returns for decile portfolios based on B/M, S/P, D/E and size (market capitalization). D1 (D10) is the decile portfolio with the lowest (highest) values. Results show consistent negative relationships with returns for B/M and S/P, and a less consistent negative relationship with returns for D/E. The size effect is concentrated in the two smallest deciles.
Within the total sample, 43% (45%) of firm-months have negative earnings (cash flows). The next table reports average monthly returns for portfolios formed on positive E/P (E/P+), negative E/P (E/P-), positive C/P (C/P+) and negative C/P (C/P-). Q1 (Q5) is the quintile portfolio with the lowest (highest) values. All results support a value interpretation of the ratios.
In summary, there is a highly significant value premium among Australian stocks, and the book-to-market ratio is the best way to capture that premium. A size effect exists only among the very smallest stocks.
