Key Points

  • We recommend using a composite of ratios when valuing a firm because no perfect measure of value exists. Doing so reduces the impact of each measure’s inherent shortcomings when the ratio is used in isolation.

  • Book value is an incomplete measure of a firm’s assets. Given the growing importance and increasing share of intangible capital in total company capital, adding measures of intangibles provides a more complete measure of firm capital.

  • Including intangibles when estimating a firm’s value has a greater impact on smaller companies. Mega-cap growth stocks, notably, the FANGs, still look expensive after incorporating intangibles in the value of firm capital.

Brent Leadbetter is the corresponding author.

We believe that when evaluating a company, relying on a single metric or ratio may not be prudent. We have shown that a combination of risk-based and reversal metrics can improve the returns of a momentum strategy (Arnott et al., 2017). We have further shown that the variations in definitions of “quality” result in vastly different portfolios and returns (Hsu, Kalesnik, and Kose, 2019). A combination of measures of a firm’s distress level, profitability, accounting practices, and spending level provides a more complete picture of the financial health of a company than any one measure on its own. Similarly, relying on a single measure of value may not be prudent.

Prospective buyers do not rely solely on price-to-bedroom ratio when assessing a home’s price. They consider location, lot size, square footage, number of bathrooms, local schools, and so on, because no single measure provides the complete picture. As investors, we also need to look beyond the standard book-to-market (B/M) ratio academic definition of value—reciprocally, the price-to-book-value (P/B) ratio—when assessing a company’s valuation.

Each commonly used ratio is an imperfect and incomplete measure. The price-to-sales ratio favors low-margin businesses. The price-to-cash-flow ratio and price-to-earnings ratio favor cyclical firms at their peak prices. Dividend yield excludes firms that do not pay dividends. And importantly, P/B fails to recognize the value of intangibles. Given the growing importance and increasing scale of intangible capital in many businesses, expanding P/B to include intangibles captures a more complete measure of firm capital (Arnott et al., 2020). In turn, a more complete measure of firm capital creates a more comprehensive measure of a firm’s assets when included in a composite of multiple fundamentals.