Value investors use a number of ratios to assess whether a stock is cheap. Everyone has their favorite. Everyone debates the merits of one versus the other. I backtested some of the popular ratios to see how they would perform if you simply split the market up into deciles and compared the cheapest to the most expensive deciles. The population I used for this analysis was the S&P 1500. In this case, we are comparing the most expensive 150 stocks to the cheapest 150 stocks. These are the total returns since 1999, with the 150 stocks re-balanced annually, because re-balancing monthly is impractical.
Below is a list of the ratios that I tested:
EBIT/Enterprise Value – This is the ratio identified by Joel Greenblatt in The Little Book that Beats the Market. EBIT is “earnings before interest and taxes”. Tobias Carlisle refers to this as the “Acquirer’s Multiple” in Deep Value.
The Enterprise Value is the total cost of the firm to an acquirer. Enterprise values are the total cost of the firm to an acquirer at the current market price. In other words, if you were to buy this company in its entirety, you wouldn’t simply pay the market price. You would also assume all of its debt obligations and would inherit all of its cash on hand. It is the cost to acquire the entire company. EV gives you a good idea of the true size of the business. The calculation for Enteprise Value is:
EV = market value of common stock + market value of preferred equity + market value of debt + minority interest – cash and investments.
Price/Cash Flow – The price per share divided by the total trailing twelve month cash flow for the last calendar year. In other words, how much total cash is the stock generating for what you are paying?
Price/Sales – The price per share divided by the total revenue per share. This ratio was popularized by Kenneth Fisher in his 1984 book Super Stocks.
Price/Free Cash Flow – Free cash flow is the company’s operating income minus its capital expenditures. Free cash flow strips away the company’s other financial performance variables and looks simply at how the core business is doing. This ratio looks at how much free cash flow is being generated per share relative to the price of the stock.
Free Cash Flow/Enterprise Value – This is the same thing as price/free cash flow, but instead compares free cash flow to the total size of the business.
Price/Book Value – Book value is the total balance sheet value of the company. It’s the simple equation Assets – Liabilities = Shareholder Equity. The goal of many asset-based value investors is to buy company’s that are trading at or below book value.
Price/Earnings – This is the most basic and common valuation metric. It takes the per share price of the stock and divides it by the earnings per share.
Price/Tangible Book Value – The same thing as price/book value, with a twist. When calculating shareholder equity, intangible assets are taken out of total assets. The goal here is to look at what assets can actually be sold and turned into cash.
The results are below:
I think it is best to look at the effectiveness of the ratio based on the difference in return between the cheapest and most expensive decile, rather than looking at its total return for the cheapest decile. A ratio that is effective in identifying cheap stocks should be equally effective in identifying expensive stocks. Based on the backtesting, the acquirer’s multiple popularized by Tobias Carlisle is the most effective. Tobias maintains a nice screener here.
Here is a visualization of the value premium in chart form:
The important takeaway is that no matter which ratio you prefer, they all work to some extent and buying expensive stocks is a risky bet. Value investors can debate about which ratio works best, but they all work! No matter how you slice it, cheap beats expensive.
PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings. Read the full disclaimer.