The Source of Value

TLDR: In this article, the authors identify the mechanism by which the value premium is realized by index investors by examining the per-share earnings of the S&P/Barra 500 Growth and Value indices from 1976 to 2000 and their returns from 1974 to 2002.

Abstract: I identify the mechanism by which the value premium is realized by index investors by examining the per-share earnings of the S&P/Barra 500 Growth and Value indices from 1976 to 2000 and their returns from 1974 to 2002. Over this period, the growth in per-share earnings and the price return for these two indices are virtually identical. It follows that the difference in their total return can be attributed entirely to the difference in their free cash flow yield. I show that this result is not an artifact of data mining, but an inescapable consequence of the regular rebalancing that these indices undergo, and propose a simple positive model of corporate earnings growth that predicts it. There is a rich literature on why the value premium exists, but little clarity on how it is realized. I identify free cash flow (which is composed of dividends, share buybacks and takeovers) as the mechanism by which the value premium is realized by index investors. Finally, I highlight a curious aspect of the risk of these two indices. The per-share earnings of the S&P/Barra 500 Value Index are more volatile than those of the S&P/Barra 500 Growth Index, while the returns of the S&P/Barra 500 Growth Index are more volatile than those of the S&P/Barra 500 Value Index.