Is the value premium a puzzle?

Abstract

This paper provides a rational explanation of the value premium within the long-run risks framework of Bansal and Yaron (2004). Consistent with the observed cash-flow dynamics, value firms in the model are more sensitive to low-frequency fluctuations in aggregate consumption than growth firms are. This is the key input that allows the model to account for the magnitude of the value premium in the data. The paper further shows that the observed heterogeneity in systematic risks between value and growth firms helps explain the cross-sectional differences in price-dividend ratios, variances and covariances of firms’ returns and, importantly, the failure of the CAPM and C-CAPM predictions, resolving the puzzle.