When a “Value” Company is not a Value
Value has broadly been accepted as an investing style, and historically portfolios formed on cheap valuations outperformed expensive portfolios. But value comes in many flavors, and the factors(s) you choose to measure cheapness can determine your long-term success. In particular, several operating metrics of value, like Earnings and EBITDA, have outperformed the more traditional Price-to-Book ratio. A possible reason for the limited effectiveness of P/B is because of the increase in shareholder transactions, primarily through the increase in share repurchases.
Valuation ratios have the benefit of being simple, but can also have flaws. Price-to-Sales has the benefit of measuring against revenue which is tough to manipulate, but doesn’t take margins into account. Price-to-Earnings measures against the estimated economic output of the company, but also contains estimated expenses which can be manipulated by managers. EBITDA-to-Enterprise Value has the benefit of including operating cost structures, but misses out on payments to bondholders and the government. Even with these flaws, the ratios are effective in practice. Historically, portfolios formed on cheap valuations outperformed expensive portfolios. The following charts show the quintile spreads two ratios within a universe of Large U.S. Stocks, stocks with a market cap greater than average, from 1964–2015.1
Quintile Spreads for Price-to-Earnings and EBITDA-to-Enterprise Value (1964–2015)
Price-to-Book is perhaps the most widely used valuation metric in the investing industry. Russell, the top provider of style indices for the U.S. market, uses the metric as its primary metric to separate stocks into Value and Growth categories. They use P/B in combination with forecasted 2-year growth and historical 5-year sales per share growth, but Price-to-Book is the chief determinant at 50% of the methodology. Their choice of Price-to-Book most likely comes from its long history in academic research. The seminal work on Price-to-Book was the 1992 Fama-French paper “The Cross-Section of Expected Stock Returns”, which established the 3-factor model of Market, Size, and Price-to-Book.
But when you start looking at the metric of Price-to-Book, a few issues start to become apparent. First, the overall spread on the factor isn’t as strong as operating metrics like Earnings and EBITDA: the spread between the highest and lowest quintile is only 2.8%, versus 5.1% for P/E and 6% for EBITDA/EV.
Price-to-Book Quintiles (1964–2015)
Second, when breaking down the effectiveness of the factor based on market capitalization, Price-to-Book is least effective with the largest cap stocks. The following chart shows the same quintile spreads of P/B in the U.S. Large Stocks universe, but separates out the smallest, middle, and largest third based on market cap. Price-to-Book degrades in effectiveness as you move up the market cap range, with the quintile spread within the largest third of stocks only at 1.2%. This is especially noteworthy because Russell market-cap weights their benchmark, and about two-thirds of the benchmark is in that top-third by market capitalization.
Price-to-Book Quintile Spreads by Market Cap Tertile
Last, the effectiveness of Price-to-Book has been waning, especially since the turn of the century. The following chart shows the rolling 20-year quintile spread, the difference between the two portfolios of the cheapest 20% and most expensive 20%. For Price-to-Book against EBITDA/EV and Price-to-Earnings, you can see how all three metrics behaved very similarly before 2000. They had generated consistent outperformance until being inverted in the dot-com bubble of the late 1990s, where the most expensive stocks outperformed. But coming out of the internet bubble, Price-to-Book has started behaving differently than other valuation ratios, degrading to the point where for the last twenty years it has had almost no discernible benefit on stock selection.
Rolling 20-Year Quintile Spread in Large Stocks (1984–2015)
On the surface, using book value in relation to price makes intuitive sense. The book value of equity is the total amount the common equity shareholders would receive in liquidation, the accounting value of the total assets minus total liabilities and preferred equity. The P/B ratio is meant as a quick measure to see how cheaply you could acquire the company. The ratio will move around based on changes in either the market value or book value of equity. But the ratio comes with assumptions. “Clean surplus accounting” is based on the assumption that equity only increases (or decreases) from the earnings (or losses) in excess of dividends. In practice, there is another influence on equity: transactions with shareholders.
When a company repurchases shares, the market effect is straightforward. The number of shares outstanding are reduced while the price remains the same, so the market capitalization goes down. When accounting for the share buybacks for financial reporting, the repurchase of shares does not create an asset as if the company had repurchased equity in another company. Instead, the equity value is decreased by the amount spent in purchasing the shares.
As a hypothetical example, take a company with a $200 million market cap, $100 million in book value of equity, and $10 million in earnings. The company has a P/E ratio of 20, and a P/B ratio of 2.
If that company becomes an aggressive repurchaser, and decides to acquire $50 million worth of its own equity, it will alter the ratios significantly. The earnings remain the same, but the market cap goes down, and the P/E will adjust down to 15. But the P/B ratio will be reduced on both the top and bottom of the ratio, and it will actually increase to 3.
As a practical example, Viacom has been aggressively repurchasing its own shares since separating from CBS in 2006, spending almost $20 billion over the last ten years. In 2015 alone, it repurchased about $1.4 billion in shares. So even though the company has been seeing retained earnings of about $1.5 billion per year, its common equity has reduced from $8 billion to $4 billion over that same time frame. 2
Historical Financial Metrics for Viacom
You can see how this distorts valuation ratios: Viacom trades at a significant discount on earnings versus the median P/E for other Large Stocks, while looking like it trades at significant premium on the book value of equity.
Historical Valuation Ratios for Viacom
A company issuing shares will have the reverse effect: the company will actually increase its book value, even though the earnings and cash flows are diluted across more investors. Any transaction for a company through the issuance or reduction of equity flows through the book value of the equity.
The following table compares median valuation ratios for companies with a market capitalization greater than average. Two groups are compared with the median Large Stock: those companies that have repurchased the most shares over the last 5 years, and those that have issued the most shares. The top 25 companies repurchasing their shares have better operating valuation metrics (i.e., Sales, Earnings, EBITDA, FCF) than the median, and the top 25 diluters have worse ratios, with the standout exception of Price-to-Book. Repurchasers have an average Price-to-Book of 4.5, almost 20% higher than the median 3.8, while Diluters look cheap with a P/B of only 2.7, an apparent discount of almost -30%.3
Valuation Ratios for Large Stocks by Share Activity
This distortion means using Price-to-Book could lead to misclassifications of stocks as a Value investment. Stocks that are cheap on operating metrics like Sales, EBITDA or Earnings could wind up classified as Growth. On the flip side, that universe could include a company that has issued a lot of stock and has inflated its book value of equity. This is something to keep in mind, as a number of quantitative managers start with the benchmark as their universe, and starting with the Russell 1000 Value could bias you towards a number of companies that look cheap on Price-to-Book, but are not cheap on other metrics.
Over the past fifty years, there has been a gradual increase in the amount of company equity transactions. In particular, larger companies have been increasing their share repurchase activity. In classifying companies based on a trailing 5-year change in shares outstanding, we can see which companies have consolidated shares by more than 5%, issued shares more than 5%, or have been relatively inactive. In 1982, the United States loosened regulation around the company’s restrictions for repurchasing shares, and there has been a marked increase in activity. This has led to a change in the overall market, where the percentage of companies inactive has been reduced from almost 60% in the 1960s, down to around 28%, with the activity mainly being driven from companies consolidating shares.4
Large Stocks by Rolling 5-Year Share Activity
Large Stocks Share Activity by Decade
This begs the question whether the gradual increase in shareholder transactions has resulted in the gradual ineffectiveness of Price-to-Book as a valuation factor. The first rule in analysis is not to confuse correlation with causation, but the rolling 20-years when Price-to-Book has been less effective coincides pretty well with the increase in shareholder transaction activity. Price-to-Book is also the least effective in the largest cap stocks, which have the largest volume of dollars affecting book value of equity. Perhaps the most interesting analysis is looking at the effectiveness of Price/Book within those Large Stocks that have been relatively inactive with shareholders over a trailing 5-year period, versus those that have been active, either on issuance or repurchase. Looking since the 1982 the legislation change, there is a different effectiveness of valuation metrics between companies active or inactive with shareholders. If your investments are focused on companies with share issuance or repurchase activity, there has been no relative benefit to buying companies that look cheap on P/B, and there’s almost no difference between high and low valuations. But if limiting to companies that are relatively inactive, you can get a spread of 6.4% between the highest and lowest 20% based on the B/P ratio. Using another valuation metric, like EBITDA/EV, works well independently of independent of a company’s activity in issuing or repurchasing shares.
Even with the long-term degradation of returns from Price-to-Book, it is possible that it will revert to an effective investment factor. Price-to-Book has been off to a strong start in 2016 and is outperforming other valuation factors, particularly in small cap stocks. But there are structural challenges to the factor and, before you use it, you should be aware of the embedded noise from repurchases that could mislead you.
Price-to-Book Quintiles by Share Activity (1983–2015)
EBITDA/EV Quintiles by Share Activity (1983–2015)
- Quintile portfolios are formed on the “Large Stocks” universe, stocks in Compustat with a market capitalization greater than average, rebalanced every month with a holding period of one-year.
- Compustat used as source for the Viacom Data.
- Compustat source used for Russell 1000V constituents, as of May 31, 2016.
- Large Stocks universe, with Compustat as source for Share Repurchases. Price-to-Earnings, or Earnings Yield, generates a spread of 5.1% between the highest and lowest quintile, and EBITDA/EV generates a 6.0% spread.