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Testing the Value Premium Down Under

Posted in Value Premium

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.

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