The Value Spread and the Value Premium

While stocks generally have done well over the last decade, the performance of growth stocks has been particularly strong. For investors looking for guidance about their relative prospects going forward, stock valuations may provide some insights.

Exhibit 1 shows that since 2010, growth stock valuations have increased—in some cases significantly more than value stock valuations. As an example, the price-to-book ratio (P/B) of large-cap growth stocks was 7.8x as of the end of 2019—a 113% increase since 2010. By comparison, the P/B ratio of large-cap value stocks increased 32% over the same period.

EXHIBIT 1 | GROWTH STOCKS HAVE BECOME INCREASINGLY EXPENSIVE

Data from 12/31/2010 - 12/31/2019. Stocksare represented by Russell size and valuation indices. Source: Morningstar.

Other valuation measures display similar trends. Exhibit 2 compares several common valuation metrics, and all show that growth stock valuations, particularly in the large-cap universe, are significantly higher today than in 2010.

EXHIBIT 2 | VALUATION METRICS FROM 2010 TO 2019

Data from 12/31/2010-12/31/2019. Stocks are represented by Russell size and valuation indices. 2010 and 2019 represented by lighter and darker shades, respectively. Circle above bars indicates change in value from 2010 to 2019. Source: Morningstar. P/B ratio is price per share divided by book value (net assets) per share. P/E ratio is price per share divided by annual earnings per share. P/S ratio is price per share divided by annual revenue per share. P/CF is price per share divided by annual operating cash flow per share.

The difference between valuations of value and growth stocks—called the valuation spread—may provide insights into subsequent return differences between value and growth stocks.

In Exhibit 3, we summarize our experiment. We look at historical monthly valuation spreads between value and growth stocks and split them into two buckets: below median and above median. We then take the subsequent five-year return difference between value and growth indices for each month in the sample and calculate the average of the five-year periods in each bucket. Data show that periods following above-median valuation spreads experienced better future relative performance for value versus growth stocks.

EXHIBIT 3 | WHAT HAPPENS AFTER PERIODS OF ABOVE-AVERAGE VALUATION SPREADS?

Data from 12/31/1979-12/31/2019. Periods greater than one year have been annualized. Past performance is no guarantee of future results. Returns are represented by Russell size and valuation indices. Total market is the average of large-cap and small-cap indices. Source: Avantis Investors, Morningstar, Russell

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