It’s well documented in the academic research on stock returns that value stocks have outperformed growth stocks. And we see the higher returns to value stocks in almost all countries. And not only has value outperformed growth, but the persistence of its outperformance has been greater than the persistence of stocks outperforming bonds.
When implementing a value strategy, many different metrics can be used. Among the most common are price-to-earnings, price-to-sales, price-to-book value, price-to-dividends and price-to-cash flow. All the various approaches produce results showing that value stocks have had higher returns than growth stocks. And the various measures produce similar results, with the weakest results coming from the use of the dividend-to-price ratio.
Given the similarity in results, the price-to-book ratio has been used the most because book value is more stable over time than the other metrics. That helps keep portfolio turnover down, which in turn keeps trading costs down and tax efficiency higher.
Recently, some passively managed funds have moved away from the single-screen metric, as their research indicates that using multiple screens produces better results. Bridgeway and Vericimetry are two examples of fund families that have adopted this approach. In addition, the funds based on the RAFI indexes also use multiple screens (sales, earnings, dividends and book value).
In other words, the search for the best metric to use when implementing a value strategy continues.
To help us out, let’s look at what the authors of the 2012 study “Analyzing Valuation Measures: A Performance Horse-Race Over the Past 40 Years,” found. They covered the 40-year period 1971-2010 examined the returns to a variety of value metrics:
- Earnings to Market Capitalization (E/M)
- Earnings before interest and taxes and depreciation and amortization to total enterprise value (EBITDA/TEV). (Total enterprise value is defined as market capitalization + short-term debt + long-term debt + preferred stock value – cash and short-term investments.)
- Free cash flow to total enterprise value (FCF/TEV)
- Gross profits to total enterprise value (GP/TEV)
- Book to market (B/M)
- Forward earnings estimates to market capitalization (FE/M)
Following is a brief summary of their findings:
- Alternative valuation metrics such as EBITDA/TEV, GP/TEV and FCF/TEV provide economically and statistically significant alphas; that is, returns after adjusting for exposure to the risks of stocks overall—small and value alike.
- EBITDA/TEV is the best valuation metric to use as an investment strategy relative to other valuation metrics. The returns to an annually rebalanced equal-weight portfolio of high EBITDA/TEV stocks earned 17.7 percent a year. They also produced a three-factor alpha of 2.9 percent.
- Cheap E/M stocks (value stocks) earned 15.2 percent a year, but showed no evidence of alpha after controlling for market, size and value exposures.
- The academic favorite, book-to-market (B/M), tells a similar story as E/M, and earns 15.0 percent for the cheapest stocks, but with no alpha (not surprising, as value as measured by B/M is one of the factors).
- FE/M is the worst-performing metric by a wide margin.
- When they analyzed the spread in returns between the cheapest and most expensive stocks, EBITDA/TEV is the most effective measure. The lowest-quintile returns based on EBITDA/TEV return 8.0 percent a year versus the 17.7 percent for the cheapest stocks. Using E/M, the spread is 5.8 percent—9.4 percent for the expensive quintile and 15.2 percent for the cheap quintile.
- There is weak evidence that FCF/TEV can identify overvalued stocks, as the -2.0 percent alpha on the most expensive FCF/TEV quintile shows.
- There is little evidence that a particular value strategy outperforms other metrics during economic contractions and expansions.
The authors also examined the hypothesis offered by proponents of long-term valuation metrics that “normalizing” earnings decreases the noise of the valuation signal and therefore increases the predictive power of the metric. Shiller’s PE10 (averages earnings over 10 years) is a commonly used metric. They found little evidence that normalizing the numerator for a valuation metric has any ability to predict higher portfolio returns. If anything, the evidence suggests that the one-year valuation measure is superior to normalized metrics.
The authors concluded: “The evidence suggests that EBITDA/TEV has historically been the best-performing valuation metric based on a variety of analyses.”
It will be interesting to see if the latest research gets incorporated into investment strategies.
Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.
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