Equity Duration of Value and Growth Indices

Abstract

This paper explores the sensitivity of stock prices to discount rate changes and cash flow timing, a concept that may be interpreted as equity duration in a manner similar to bonds. We demonstrate the computation of equity duration using a residual income model and provide duration estimates for value and growth stocks from 2006:I to 2014:I based on forward looking analysts’ estimates. We find that growth stocks exhibit higher duration than value stocks consistent with the expectation that a higher proportion of cash flows from growth stocks will be received in the more distant future. Over our sample period, return forecasts based on duration track actual price changes of value stocks reasonably well. However, neither the residual income model nor a dividend discount model explains actual price changes of growth stocks very well. We argue that value stocks’ greater bond-like characteristics and more stable durations over time make them more amenable to the application of duration concepts than growth stocks. The larger proportion of value associated with embedded options, and the inherent challenges in modeling the sensitivity of this component to discount rate changes makes application of duration to growth stocks less useful.