Written by Liam Flavelle on 15 January 2018
- Price to Earnings and Price to Book ratios provided the best indicator of higher returns in 2017.
- Price to Cashflow and FreeCashflow were the factors to avoid, although returns were still positive.
- Value ratios are best used to compare stocks of the same sector.
- Using a combination of all value ratios gives far better results than using any one factor in isolation.
Most investors use value ratios in one form or another, whether to quickly ascertain the "cheapness" of a stock or to help provide a more in-depth view of a company's financial health.
What most investors don't understand is how good their ratio of choice is at predicting future returns, so we decided to research how 8 common ones performed, both in 2017 and since 2010.
We used the InvestorsEdge.net platform to perform our research and to provide our results - you can find lots more risk/return information and position data for each individual test by clicking here (to access all the tests, click on the History button on the left hand menu).
We selected 8 of the most popular value ratios to test:
- P/E - The Price to Earnings ratio, calculated by dividing a company's current price by its Earnings Per Share over the past 12 months, is probably the most quoted factor of our test. Lower values can indicate an undervalued stock.
- Price to Book - A company's book value represents its theoretical value if all its assets were liquidated today - stocks with low P/Book ratios could be undervalued as you may be paying a bargain price for their assets.
- Price to Tangible Book - A company's tangible book value is similar to its book value, except it only includes assets on the balance sheet that you can effectively see or touch and ignores items such as patents, trademarks, goodwill and copyrights.
- Price to Free Cash Flow - Free cash flow is a company's operating cash flow less capital expenditures, and represents the cash it generates after spending the cash required to maintain or expand its asset base. Companies with low P/FCF ratios could be undervalued as they are generating lots of free cash for future investment / returns to shareholders for a given price.
- Price to Sales - an indicator that works surprisingly well historically, this identifies undervalued companies by dividing their price by their revenues per share. A lower value is assumed to indicate a mis-priced stock.
- EV to EBITDA - A company's enterprise value is a measure of its total value whilst EBITDA is a representation of profitability. When you divide one by the other, those stocks with a higher ratio could be undervalued as you may be paying less money to acquire a company with higher profits relative to its peers.
- EV to EBIT - Similar to EV to EBITDA, EBIT includes depreciation and amortization in a company's earnings figures.
We ran 2 sets of tests across our ratios to see how they performed. The first set of tests (in green/red below to indicate over- or under-performance to its 8 year average) covers 2017, while the second set (in yellow) shows us how each ratio has performed in the 8 years since 2010.
Our theoretical strategy selects on a weekly basis the best 50 stocks when ranked by each value ratio. Each test was run 3 times, ranking stocks based on their performance within their respective sectors, industries and within the entire universe of stocks.
As a final experiment we also included a combined version of our test, that selected stocks based on how they ranked across all of our ratios.
You can see from the result table that the humble P/E ratio made a come back this year along with the classic value factor, Price to Book. On a risk-adjusted basis both of these ratios showed the most consistent returns with the highest Sharpe Ratios of the test.
Cash Flow and Free Cash Flow ratios showed significant under-performance in 2017 when compared to their peers and to their historical averages, while the Price to Sales returns were mixed across its universe, sector and industry tests.
To research our value ratios we put together a theoretical trading strategy that included all US common stocks and ADRs with a Market Capitalization greater than US£250m. On the 1st January 2017 this would have given us a universe of 3404 stocks.
Each week starting on 1st January 2017 our strategy ranks our universe by each value metric, and selects the top 50 with the best value (for Price ratios lower numbers are better, for EV-based ratios larger numbers are preferred). A second test then compared and ranked stocks within their respective sectors before selecting the top 50, while a third ranked stocks within their industries.
The strategy then simulates buying and selling the selected shares for each week in 2017 and shows us how each ratio would have performed over the selected period.
Since this is a research project to identify the behaviours and performance of value ratios, no commissions or other trading costs have been accounted for.
Three key takeaways are immediately apparent when looking at our results - firstly and perhaps contrary to popular opinion, value investing as a philosophy still worked in 2017.
What changed was the ratios that worked best during that period - Cash Flow and Free Cash Flow had a storming 2016 followed by a very poor 2017, whilst Price to Book and P/E, which has had a poor run of identifying undervalued companies in the last few years, suddenly became very reliable predictors of a stock's improving fortunes.
Secondly, price ratios are better used to compare stocks with peers in their respective sectors, and enterprise value-based ratios in their respective industries.
Lastly, our research confirms the acknowledged wisdom that it is far better to use a combination of ratios rather than any one in isolation. Our combined strategy consistently out-performed the individual ratios on both a total- and risk adjusted-return basis over both test periods.
We'll be providing a monthly review of the performance of these value ratios from now on - if there's a factor that we haven't included let us know and we'll start tracking it.