First Draft: August 2004 This draft: August 2007 Comments welcome

The Anatomy of Value and Growth Stock Returns Eugene F. Fama and Kenneth R. French*

Abstract We break average returns on value and growth portfolios into dividends and three sources of capital gain, (i) growth in book equity primarily due to earnings retention, (ii) convergence in price-tobook ratios (P/B) due to mean reversion in profitability and expected returns, and (iii) upward drift in P/B during 1927-2006. The capital gains of value stocks trace mostly to convergence: P/B rises as some value firms become more profitable and their stocks move to lower expected return groups. Growth in book equity is trivial to negative for value portfolios, but it is a large positive factor in the capital gains of growth stocks. For growth stocks, convergence is negative: P/B falls because growth firms do not always remain highly profitable with low expected stock returns. Relative to convergence, drift is a minor factor in average returns.

Graduate School of Business, University of Chicago (Fama), and Amos Tuck School of Business, Dartmouth College (French). We are grateful for the comments of Jonathan Lewellen.

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Value stocks (with low ratios of price to book value) have higher average returns than growth stocks (high price-to-book ratios). (See, for example, Rosenberg, Reid, and Lanstein 1985, Fama and French 1992.) Our goal is a better understanding of the sources of this value premium in returns. The one-period simple return on a stock from t to t+1 (Rt+1) is commonly broken into a dividend return (Dt+1/Pt) and a capital gain return (Pt+1/Pt). (1) 1 + Rt+1 = Dt+1/Pt + Pt+1/Pt . To better understand the average returns of value and growth stocks, we examine the sources of capital gain. In our initial tests we break the capital gain return into two pieces. The first is the growth rate of book