There is a Growth Premium After All
52 Pages Posted: 19 Jun 2017 Last revised: 8 Aug 2018
Date Written: February 6, 2018
The conventional wisdom argues that the growth stocks are riskier to earn a higher premium. However, the empirical evidence points out that the value stocks, which are classified based on the book-to-market ratio, tend to have a higher premium. To solve this tension, this paper decomposes the book-to-market ratio into two components, a trend component, and a temporary (innovation) component. Both economic interpretation and empirical results show that the temporary component has a strong negative relationship with future cross-sectional stock returns even after controlling for main return predictors including Book-to-Market ratio, while the trend component is positively associated with the value premium. Therefore, consistent with conventional wisdom, our results confirm that there is growth premium captured by the temporary component of the book-to-market ratio.
Keywords: Book-to-Market ratio, Temporary Component of B/M, Growth Option, Growth Premium
JEL Classification: G12
Suggested Citation: Suggested Citation