What it means
Book value is the net worth of a company according to its balance sheet, and market value is what investors collectively pay for it. The book-to-market ratio divides one by the other.
A high ratio means the market values the company at little more than its accounting value, which is typical of so-called value shares, and a low ratio is typical of growth shares. Economists Eugene Fama and Kenneth French showed in the early 1990s that value shares have historically earned higher average returns than growth shares.
This pattern could not be explained by market risk alone, so they added HML to the original model as an extra factor. The result became known as the Fama-French three-factor model.
To build HML, shares are ranked by book-to-market ratio and sorted into groups. The factor is the average return of the value group minus the average return of the growth group, so it is positive when value does better and negative when growth does better.
Because the portfolios are built to be roughly neutral to company size, the factor aims to isolate the value effect. Practitioners use HML in several ways.
Fund analysts regress a fund's returns on HML to see how much of its performance comes from a tilt towards value, and companies use factor models to estimate the cost of equity. Investors also use it to understand why a portfolio lags in a period when growth shares lead.
There is debate about what HML really measures. Some argue it compensates investors for the risk of financially stressed firms, while others say it reflects investor mistakes.
The factor has also gone through long periods of weak returns, so it is not a reliable source of profit in every period. A related factor is Small Minus Big, which captures the return of small companies over large ones.
The two are often used together with the market factor, and more recent models add profitability and investment factors. Each additional factor is meant to explain more of the differences in returns between portfolios.
In practice
Real-world examples.
Example
A fund analyst regresses a manager's returns on market, size and HML factors. The result shows a large positive HML exposure, so most of the outperformance is explained by a value tilt rather than by stock picking.
Example
A corporate finance team estimates its cost of equity with a three-factor model. The company is a mature manufacturer with a high book-to-market ratio, which adds to its required return compared with a simple market-only model.
Example
A pension trustee asks why the fund's value-oriented manager has lagged for three years. The consultant shows that HML has been negative over the period, which explains most of the underperformance.
Formula
Calculation
HML = average return of value portfolios - average return of growth portfolios
In the standard method, HML = 1/2 x (small value + big value) - 1/2 x (small growth + big growth).
Suppose that over a year the four portfolios earned: small value 14%, big value 10%, small growth 8% and big growth 6%.
Value average = (14% + 10%) / 2 = 12%.
Growth average = (8% + 6%) / 2 = 7%.
HML = 12% - 7% = 5%.
A positive 5% means value shares beat growth shares by five percentage points that year. If a fund has an HML exposure (beta) of 0.4, this factor would add about 0.4 x 5% = 2% to its expected return in that period.Case study
Seen in the real world.
Ashgrove Pensions is a fictional scheme that hired two managers, one growth-focused and one value-focused. After five years, the value manager trailed the growth manager by 3% a year, and some trustees wanted to dismiss her.
An adviser measured both managers against factor returns. In this illustrative review, almost all of the gap came from HML being negative over the period, and after adjusting for it the value manager's skill was positive by about 0.5% a year. The trustees kept both managers, treating the style difference as a deliberate diversification choice rather than a failure. They also agreed to review managers over full market cycles of at least seven years, so that a temporary swing in style would not decide the outcome.
Watch out
Common mistakes.
- Assuming HML always earns a positive return, when it can be negative for years at a time.
- Confusing a low price with good value, when a high book-to-market ratio can also signal a company in trouble.
- Reading the factor as a tradeable guarantee, when real portfolios face costs, taxes and practical limits.
Questions
People also ask.
What does high minus low mean?
It means the return of high book-to-market (value) shares minus the return of low book-to-market (growth) shares.
Who created the factor?
Eugene Fama and Kenneth French introduced it in their work on the three-factor model.
What is a book-to-market ratio?
It is a company's accounting net worth divided by its market value, and a high ratio means the market values it close to or below book.
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