Swedroe: Not All Value Metrics Are Equal

July 21, 2014

Know how the 'value' of your value stocks is determined.

The metric most commonly used to categorize value stocks and to construct portfolios is the one employed by the Fama-French three-factor model—book-to-market (BtM) ratio. Russell Indexes only uses BtM to determine value as well.

However, other metrics also show a value premium.

Today we'll take a look at the historical evidence on the premiums provided by four additional value metrics: dividend-to-price (D/P); book-to-price (B/P); cash flow-to-price (CF/P); and earnings-to-price (E/P).

The data in the table below shows the annual average returns from 1952-2013—the longest period for which data is available for all four metrics—for the highest 30 percent of stocks ranked by each metric minus the annual average returns of the lowest 30 percent of stocks within that same metric.

Note that the data is based on the total stock market. This matters because the B/P ratio is less strong in large-cap stocks, and the total market is dominated by large-cap stocks. The data below are from the Fama-French data series.

Annual Average Returns 1952-2013

Value Metric Average Annual Return (%) T-Statistic
D/P 2.17 0.87
B/P 4.43 2.54
CF/P 5.11 3.19
E/P 6.73 3.57





As you can see, the D/P ratio (dividend-to-price), while it provides exposure to the value premium, has produced the lowest returns. The D/P premium is also the only one that isn't statistically significant. In other words, while a high-dividend strategy is a value strategy, it's a weak one. The highest annual premium has historically been provided by E/P (earnings-to-price).

Changing focus to book-to-price (B/P), one reason that the B/P metric has been commonly used to determine value is that the book value of a company is more stable that E/P because B/P is a cumulative measure. This is important because the more volatile the metric used, the higher the turnover of the strategy will be. And while strategies have no costs, implementing a strategy does.

This cost consideration is especially important when constructing portfolios of small-cap value stocks. Another aspect to think about is that the E/P metric is more easily manipulated than either book value or cash flow.

Some fund companies have developed strategies that use multiple metrics with various weighting schemes, believing that this provides a diversification benefit. While the correlation of returns to the four metrics is highly positive, they aren't perfectly so.

Another reason for using the E/P and cash flow-to-price (CF/P) metrics in the portfolio construction rules of a value strategy is related to the comparatively new profitability factor. The research has found that the E/P and CF/P factors, as well as a multifactor approach, provide more exposure to the gross profitability strategy than does B/P.

The bottom line is that not all value metrics are the same. Thus, when deciding on which fund you choose to implement your value-oriented portfolio strategy, you should consider the construction design rules used by the fund to make sure they provide you with the exposure to the value factor—and perhaps the profitability factor—you're seeking.

Not all value funds are created equal in their exposure to the various factors.

Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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