The Source of Value

Abstract

There is a rich literature on why the value premium exists, but little clarity on how it is realized. The author identifies free cash flow (composed of dividends, share buy-backs, and takeovers) as the mechanism by which the value premium is realized by index investors. He examines the per-share earnings of the S&P/Barra 500 Growth and Value indexes from 1976 to 2000 with their returns from 1974 to 2002. Over this period, the growth in per-share earnings and the price return for the two indexes 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. The author shows that this result is not an artifact of data mining, but rather an inescapable consequence of the regular rebalancing that these indexes undergo. He proposes a simple positive model of corporate earnings growth that predicts it. A curious aspect of the risk of the two indexes is that the per-share earnings of the S&P/Barra 500 Value index are more volatile than the per-share earnings of the S&P/Barra 500 Growth index, while the returns of the growth index are more volatile than those of the value index.