Question

A well-documented fact in finance research is the value effect or the value anomaly.

4.2 Which ratios are usually employed to distinguish between value and growth stocks? How do these studies demonstrate the difference between value stocks and growth stocks?

4.3 Based on mistakes of judgment, present reasons for the difference of value versus growth stocks.

4.4 Based on agency considerations, present reasons for the difference of value versus growth.

4.5 Explain the arguments of Fama and French who support that risk considerations can explain these "anomalies".

Answer 1

4.2 price-to-earnings (P/E) ratios & high price-to-book ratios are usually employed to distinguish between value and growth stocks.   Growth stocks generally have high price-to-earnings (P/E) ratios and high price-to-book ratios. The P/E ratio is the market value per share divided by the current year’s earnings per share.  Value stocks generally have low current price-to-earnings ratios and low price-to-book ratios. Investors buy these stocks in the hope that they will increase in value when the broader market recognizes their full potential, which should result in rising share prices. Thus, investors hope that if they buy these stocks at bargain prices and the stocks eventually increase in value, they could potentially make more money than if they had invested in higher-priced stocks that increased modestly in value.

4.3 Growth Vs. Value. The concept of a growth stock versus one that is considered to be undervalued generally comes from fundamental stock analysis. Growth stocksare considered by analysts to have the potential to outperform either the overall markets or else a specific subsegment of them for a period of time

Investors who purchase growth stocks receive returns from future capital appreciation (the difference between the amount paid for a stock and its currentvalue), rather than dividends. ... Value stocks are those that tend to trade at a lower price relative to their fundamentals (including dividends, earnings, and sales).

4.4 When investing long term, some individuals combine growth and value stocks or funds for the potential of high returns with less risk. This approach allows investors to, in theory, gain throughout economic cycles in which the general market situations favor either the growth or value investment style, smoothing any returns over time.

4.5 Support for market efficiency has been provided by Fama–French (1993, 1996) who show that, except for the momentum effect, the impact of security characteristics on expected returns can be explained within a risk-based multifactor model. However, there is still an ongoing debate about whether expected returns are explained by risk factors or by non-risk firm characteristics.