I recently read an article about Netflix and Meta (formerly Facebook) recently becoming ‘value stocks’ due to the significant drops they have both had in their share prices this year (Meta is down 52.3% Year-to-Date and Netflix is down 62.5% Year-to-Date as of this writing). You have heard us talk about value stocks many times before, as it is typically a tilt we hold in our portfolios, but what exactly is a value stock?
One of the ways to measure how a stock is trading is through a metric known as the price-earnings ratio. This calculation measures the multiple of earnings a stock is trading at by taking its stock price and dividing it by the earnings per share of the company. The price-earnings ratio is one of the main ways to classify what a value stock is versus value’s counterpart, a growth stock.
Over the last 20 years, large cap value stocks have traded at a 13.7 price-earnings ratio while growth stocks have traded at an 18.6 ratio. To put it simply, you are paying more per $1 of earnings if you buy a growth stock versus a value stock, on average. Therefore, it costs less per dollar of earnings to acquire value stocks than growth stocks. If we pay less for the stocks we acquire, the probability of realizing a stronger long-term return should increase.
This is one of the fundamental reasons we tilt towards value, because paying less for a stock should give us a better chance of stronger long-term returns. Of course, this is only one factor, and certainly is not the end-all-be-all, but when we find a logical theory that is shown to work more than it doesn’t (U.S. value stocks have outperformed U.S. growth stocks in 80% of 10-year rolling time periods since 1926), we tend to like those odds.
Can you now spot the difference between value and growth?
Source: Yahoo Finance, JP Morgan Guide to the Markets, Dimensional Fund Advisors LP