Investors may be relying too much on a once proven tool that isn’t paying as well today. This means that investors may need to do more homework if they want to identify valuable stocks in the future.
WWhat if a fundamental method that investors relied on for decades to find cheap but promising stocks to buy low and sell high no longer worked?
The book-to-market ratio has been used since at least the Great Depression to identify undervalued stocks. But it has become so detached from a modern research and intellectual property-driven economy that it no longer accurately reports so-called value stocks, suggests new research from Charles CY Wang, Glenn and Mary Jane Creamer associate professor. Business Administration at Harvard Business School.
Investors use book-to-market ratios to spot potentially undervalued stocks, and major stock indexes and institutional investors rely on this metric as well. Yet when examining thousands of stocks over a period of nearly 40 years, Wang and colleagues find that the correlation of the book-to-market ratio with other valuation ratios has fallen from 75% to 45%. The measure no longer accurately predicts future returns and growth, while other valuation measures continue to do so.
At a time when some wonder if the stock market is overvalued and may experience some volatility as the economy continues to recover, Wang’s research suggests that investors may be relying too much on a formerly proven tool that doesn’t. not paying as much as well today. This means that investors may need to do more homework if they want to identify any valuable stocks in the future.
“We are taught that there are extremely smart people working in the market, and therefore we should expect the markets to be somewhat efficient,” Wang said. “But index providers and institutional investors still rely on increasingly imperfect metric to identify stocks of value.”
Wang teamed up with Ki-Soon Choi and Eric C. So of the Sloan School of Management at the Massachusetts Institute of Technology to write the new research, titled Going by the Book: Valuation Ratios and Stock Returns.
A closer look at stock market values
The book-to-market ratio takes a company’s book value and compares it to its market capitalization, or net market value. Book value is the value of a company’s assets, including land, equipment, and patents, and minus the value of liabilities like debt, essentially an accounting estimate of the value available to shareholders if the company was liquidated. Market value reflects the total value of the outstanding shares of a public company based on the market price of a share. A stock with a lower book-to-market ratio, for example when it is less than 1, is considered relatively cheap and should signal higher future returns.
To find out how accurately this ratio predicted a stock’s returns, the authors gathered data from Standard & Poor’s Compustat and the Stock Price Research Center, or CRSP, and Thomson’s mutual fund holdings. Reuters S12. They then looked at stocks with positive book values traded on the New York Stock Exchange, Amex and NASDAQ.
In total, Wang and his colleagues looked at 84,837 data points of companies with at least 10 months of measurements from 1980 to 2017. The authors excluded financial companies and companies with stock prices below $ 5.
The researchers then compared the book values to market values of companies with four alternative valuation ratios that they devised: sales-to-price, gross profit-to-price, net-to-price payments, and a composite ratio. The researchers found that while these ratios all worked well in predicting stock returns in the 1980s and 1990s, the book-to-market ratio no longer performed well between 2005 and 2017, while the alternative ratios did. continued to do so.
“I was really surprised at how badly the book-to-market is doing, when all other valuation metrics seem to have preserved this ability to help investors identify stocks of value,” said Wang.
Why the metric is not working
One of the reasons the metric has become less reliable over time? The transition to a knowledge-based economy, say the researchers.
Business investments in intangible assets (knowledge and organizational capital development, intellectual property, brand recognition or customer loyalty) have become increasingly important over the past 10 to 15 years, according to the researchers. However, accounting principles generally accepted in the United States treat these investments as expenses that are deducted from income and do not consider them as assets on the balance sheet. Such investments will therefore depreciate the book value of equity.
“For tech or healthcare companies, market values can seem high relative to book value. But the market might think, “Well, these companies have made significant investments in R&D which probably have economic value.” It’s just that they don’t show up on the balance sheet, ”Wang said. These distortions make it difficult to compare the book-to-market ratio between companies that make different types of investments or over time.
Share buybacks and dividends, which reduce cash flow and the book value of equity, also skew the book-to-market ratio, the researchers say. It is no coincidence that the growing popularity of buyouts and the importance of intangible investments in recent years have coincided with the decline in the effectiveness of the book-to-market ratio as a predictor of return.
“Ultimately that’s why we want to use these metrics to help us identify stocks that are most likely to generate good returns,” Wang said.
What should an investor do?
Due to this changing landscape, investors should consider alternative valuation ratios or perform detailed intrinsic valuation analyzes, Wang advises. Specifically:
Consider a broad set of metrics. Investors who rely on valuation ratios to identify stocks of value should consider a broader set of metrics, such as sales / price, gross profit / price, net payouts / price, and profit / price. This approach would tell an investor whether a stock is cheap or expensive with more confidence.
Go beyond ratios. Consider doing a discounted cash flow analysis to estimate the intrinsic value of the stock. Comparing the intrinsic value of a stock to its market price is ultimately the most conceptually correct approach.
The creators of stock indexes and funds based on them should also reconsider how a value stock is determined, Wang said.
For example, FTSE Russell, the leading provider of style indices in the United States, gives a 50% weighting to book-to-market ratios when considering companies to be part of the Russell Value 3000, Russell Value 2000 indices. and Russell Value 1000. According to the authors, replacing the book-to-market ratio with more relevant valuation ratios will produce more representative value equity portfolios.
“Hope is not lost,” says Wang. “We’re not saying just ignore accounting because it’s unnecessary. In fact, what people should learn from this is that you are really learning about accounting and its nuances. And when you know accounting, you can and you will know how to make it all work. “
Rachel Layne is a writer based in the Boston area.
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[This article was provided with permission from Harvard Business School Working Knowledge.]