Risk glossary

 

Value factor

The value factor is an attribute of stocks that are chosen by factor investors. The value factor is based on a belief that stocks that are inexpensive relative to some measure of fundamental value outperform those that are pricier.

The value factor has a long history in financial research starting in 1930s when academics developed a methodology for identifying stocks trading less than their actual value, and later linked the performance of stocks to their price-to-earnings (P/E) ratios. However, the best-known work on the value factor was carried out by Eugene Fama and Kenneth French in their 1992 paper, The cross-section of expected stock returns, which concluded that low price-to-book ratio was the most predictive definition of value.

To this day, different definitions of value are favoured by institutional investors, including cashflows, prices relative to earnings, dividend yield, and other company fundamentals.

Like the quality premium, the cause of the value premium is also disputed. While it is obvious that cheaply valued assets deliver higher returns, it is difficult to understand why the premium persists in an efficient market, where stocks that are undervalued should be identified quickly attracting buyers.

One explanation for this persistence is that cheap companies tend to exhibit less stable earnings and higher debt levels for which investors demand compensation in the form of higher returns. Another explanation is that investors tend to shun stocks that have underperformed in the recent past.

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