When a “Value” Company is Not a Value

Value has broadly been accepted as an investing style and, historically, portfolios formed on cheap valuations have outperformed expensive portfolios. But value comes in many flavors, and the factor(s) you choose to measure cheapness can determine your long-term success. In particular, several operating metrics of value, such as earnings and EBITDA, have outperformed the more traditional price-to-book (P/B) factor. A possible reason for the limited efficacy of price-to-book is because of the increase in shareholder transactions, primarily through the increase in share repurchases.

Valuation factors have the benefit of being simple, but can also have flaws. Price-to-sales has the benefit of measuring against revenue, which is difficult to manipulate, but it doesn’t take margins into account. Price-to-earnings (P/E) measures against the estimated economic output of the company, but also contains estimated expenses that can be manipulated by managers. EBITDA-to-enterprise-value (EBITDA/EV) has the benefit of including operating cost structures, but it misses payments to bondholders and the government. Even with these flaws, the factors are effective in practice. Figure 1 shows the quintile spreads of two factors within a universe of U.S. Large Stocks from 1964 through 2015.1

Price-to-book is perhaps the most widely used valuation factor in the investing industry. Russell, the top provider of style indexes for the U.S. market, uses the factor as its primary metric to separate stocks into Value and Growth categories. They use price-to-book in combination with forecasted two-year growth and historical five-year sales-per-share growth, but price-to-book is the chief determinant, comprising 50 percent of the methodology. Russell’s choice of price-to-book most likely comes from its long history in academic research. The seminal work on price-to-book is Fama-French’s 1992 paper “The Cross-Section of Expected Stock Returns”, which established the three-factor model of Market, Size, and Price-to-Book.

But when you start looking closely at price-to-book, a few issues start to become apparent. First, the overall spread on the factor isn’t as strong as it is with other operating metrics. The spread between price-to-book’s highest and lowest quintiles (see Figure 2) is only 2.8 percent—versus price-to-earnings’ 5.1 percent spread and EBITDA-to-enterprise value’s 6.0 percent spread.