Just want to clarify this
Can some one explain this component and what the HML implications are in the FAMA French Model?
Does it mean that if the company has high growth prospects it has a negative sensitivity to Beta?
High book-to-market ratio >>>> The stock is trading at a price relatively low to its book value (value stock)
Low book-to-market ratio >>>> The stock is trading at a price relatively high to its book value (growth stock)
The first one implies that the stock has an unused upside (the current price is low and can rise)
The second one implies that the stock has used its upside (the current price is high and will not rise more)
Fama and French discovered that stocks with high book-to-market ratios (H) outperformed stocks with low book-to-market ratios (L) over an observed period of time. Therefore you calculate H returns minus L returns.
If a stock has low book-to-market ratio, its beta(HML) must be negativve. A negative beta would imply a lower required return because you are more willing to pay a higher price for a stock with earnings that are expected to show high growth. Since many investors look the valuation this way, value stocks tend to be overvalued, so they underperform value stocks (high B-M ratio)
Hope this helps.
Thanks a lot.
That was a very detailed explaination and it helped me understand the concept.
Just a clarification did u mess up the 2 lines in bold due to typos?
Can you specify the mistake in those lines? I see nothing.
The first line means that a value stock has a low market price relative to its book value because the company growth prospects are bad, so the stock price is trading at a discount maybe (probably undervalued). However, that scenario can change and its price could rise in a good pace. Good profit to the investor at the end.
The second line means that a growth stock has a high market price relative to its book value because a high earnings growth prospect. Since those expected growths are collapsed in the price, the valuation can be erroneous and the price be overvalued. The price has already used its upside and therefore the only way it could move is down (assuming no change in the company prospects). Bad profits at the end for the investor that bought an overvalued stock.
Fama and French discovered that growth stocks underperformed value stocks for a period of time. I still think this is true, that’s why researchers look for low P/E stocks (rare to see). All those concepts are linked.
Regards.
I am sorry, I think I got a bit confused.
The thing is that here you are comparing one company being over/under valued with itself.
If Value prospect is high (company A) in relation to another company having high growth prospects (company B), then isnt company B undervalued?
Considering the fact that Company B is selling for a lower price per unit of Earnings?
Again, I am sorry for bothering you with this and making it complicated.