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Value premium is an attempt to quantify the difference between value stocks and growth stocks to allow an investor to make informed investment decisions. The concept of the value premium was developed in 1992 by economists K. G. French and Eugene Fama, although some critics argue it is not a meaningful measure. Investors who use this calculation in their decision making tend to consider other factors as well, balancing multiple pieces of information about prospective investments so they can make the best choice.
To find the value premium, investors look at the difference in value between value stocks and growth stocks. Value stocks appear underpriced, with a high book to market ratio; their actual book value is larger than their value as assessed by traders in the open market. Growth stocks have a low book-to-market ratio, indicating they are selling on the open market for more than their book value would suggest they are worth. Investors with a growth investment strategy may seek these securities out with the goal of growing a profit quickly, while value investors purchase value stocks in the hopes of capitalizing on them later.
An investor looks at the difference between the top and bottom 30 securities in terms of book-to-market ratio in the process of making this calculation. A high value premium can indicate the possibility of substantial potential for profit by investing in value stocks and holding them until their market value approaches their book value. Lower premiums may suggest growth stocks could be a better buy.
Critics of this approach to valuing investments argue the value premium is more dependent on the period of time being measured than it is on risk. Using a value premium may not help people avoid risk, depending on when they perform the calculation, as the stock market shifts regularly and these shifts are not dependable or predictable. Supporters believe this calculation can provide guidance for people interested in determining the costs and benefits of value versus growth investments.
Financial publications regularly provide rankings of growth and value stocks, sometimes with in-depth discussions of specific stocks to help guide investors. People can use these rankings to determine value premium. It can be helpful to compare premiums across different periods of time to see how much fluctuation over time plays into the value premium, and to use other investment rankings and advice to guide investment decisions.
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