Traditionally, a company’s value is based on what’s known as the book-to-market ratio — or else the inverse, market-to-book. A company’s book value is calculated by subtracting the value of a company’s liabilities from the value of the assets on its balance sheet. Its market value is the current share price multiplied by the number of shares issued.
Increasingly, though, experts are questioning the emphasis on book-to-market. As LARRY SWEDROE explains, new research appears to strengthen the case for a broader definition of value.
Dating back to the 1930s work of Graham and Dodd, academics and practitioners have used the book-to-market (B/M) ratio to measure how cheaply firms’ net assets could be acquired. However, intangible assets now make up a much larger component of a firm’s value, as there has been a dramatic shift to a more knowledge-based economy — public companies’ most valuable “assets” are now often related to intellectual property, brand recognition and customer loyalty, which are typically omitted from firms’ balance sheets.
Ki-Soon Choi, Eric So and Charles Wang contribute to the factor literature with their May 2021 study, Going by the Book: Valuation Ratios and Stock Returns. They examined the use of firms’ B/M ratios in value investing strategies and its implications for the cross-section of stock returns and trading activity. Their study was “motivated by secular trends within the U.S. economy in recent decades that distort firms’ reported book values (i.e., the shareholders’ equity reported on firms’ balance sheets) as an estimate of the residual liquidation value available to shareholders.”
They began by noting: “Under GAAP [generally accepted accounting principles] accounting, firms are required to expense research and development (R&D) and advertising expenditures, which lower book values by reducing retained earnings, regardless of whether the expenditures are expected to generate net assets. Thus, when omitting key ‘assets’ for some firms, the ratio of book values to market prices (i.e., B/M) can provide a distorted view of the value proposition of buying firms’ net assets. Another distorting factor is the growing trend in shareholder payouts, for example due to share repurchases, which lower both book value and market capitalisation. Because most stocks have a B/M below one, cash payouts to shareholders tend to lower a firm’s B/M even if the firm’s expected returns and growth prospects are unchanged. Thus, similar firms can have varying B/M ratios due to different payout policies.”
Despite the changes, they noted: “At the time of this writing, major stock indexes and investment firms report using nook-to-market to identify value stocks, reflecting the continuation of a practice that has been in place for several decades. For instance, the FTSE Russell, the top provider of style indexes in the U.S., uses B/M in determining the Russell Value 3000/2000/1000. Its methodology for identifying value stocks places 50% weight on B/M, by far the most heavily weighted input. Similarly, Barra, one of the top risk and performance tracking data providers, focuses exclusively on B/M in some of its value/growth indexes.”
Choi, So and Wang hypothesised that because institutional investors commonly construct their product offerings to mimic or benchmark against branded indexes such as the Russell Value 3000 to attract and retain capital, investor demands for stocks within a given B/M portfolio move in concert. Thus, they expected that the correlated demand results in stocks trading like their B/M peers despite B/M losing its informativeness about similarities between firms in terms of their expected returns and growth.
To assess the role of investors’ reliance on book-to-market, Choi, So and Wang identified cases where B/M significantly deviated from other relative value measures that they referred to as “benchmarks”. They selected specific ratios as benchmarks of comparison that serve a similar purpose as B/M but whose numerators are less likely affected by the secular trends in the economy that motivated their study. Their benchmarks included: sales-to-price (S/P), gross-profit-to-price (G/P), net payouts to shareholders-to-price (N/P), and a composite (COMP). By identifying significant deviations between B/M and these benchmarks, they were able to study how investors price and trade stocks when facing conflicting value signals. Their data sample covered the period 1980-2017. Following is a summary of their findings:
- Coinciding with a steady increase in firms’ off-balance-sheet intangible assets, goodwill, and stock issuances and repurchases, correlations between book-to-market and their benchmarks steadily declined over time — consistent with B/M becoming a noisier signal of stocks’ value status. For example, the average cross-sectional correlation between B/M and COMP fell from approximately 0.7 to 0.45 during the sample period.
- Book-to-market has gradually detached from common alternative valuation ratios over time, and has become worse at forecasting future returns and fundamental growth in both an absolute and a relative sense—the same is not true of the benchmark ratios.
- Higher values of “RatioSpread” (the absolute spread in each firm’s book-to-market ranking relative to its ranking based on the benchmarks) corresponded to cases where firms appeared as value firms in terms of B/M but as glamour firms in terms of their benchmarks, or as glamour firms in terms of B/M but as value firms in terms of their benchmarks.
- Extreme values of RatioSpread have become increasingly prevalent over time.
- When RatioSpread was large, book-to-market performed predictably worse in forecasting future stock returns and growth in firms’ fundamentals.
- Firms’ returns and trading volumes correlated more with benchmark peers (i.e., firms with similar benchmark ratios) compared to book-to-market peers, in cases where the firms appeared as a value stock in terms of the benchmarks but as a glamour stock in terms of B/M.
- Stocks have continued to trade as if book-to-market outperforms other ratios as an indicator of firms’ future performance despite the opposite being true — firms’ stock returns and trading volumes predictably co-move along B/M in excess of fundamentals, particularly among stocks held by value-oriented funds.
- Annual stock returns were predictably lower in cases where the firm appeared as a value stock in terms of book-to-market but as a glamour stock in terms of the benchmarks — consistent with buying pressure from value-index tracking funds artificially inflating prices among some firms.
Their findings led Choi, So and Wang to conclude that their findings “point to a time-series decline in the signal content of book-to-market, rather than the overall efficacy of value investing disappearing.” They added: “Our findings suggest some institutions have been slow to adapt to the declining relevance of book values for selecting value stocks and, in doing so, helping to shape the cross-section of stock returns and trading activity.” They recommended that “investors should substitute away from B/M for value investing, especially when B/M differs from other ratios.”
Finally, Choi, So and Wang did note that with appropriate adjustments, book-to-market can remain a useful part of investors’ value investing signals. They offered two alternatives:
- An adjusted measure of book value — a firms’ reported book value after capitalising knowledge and organisation capital using the perpetual inventory method and subtracting goodwill.
- A residual income valuation method, which relies on earnings forecasts.
Choi, So and Wang demonstrated that fundamental changes in the economy have led to a reduction in the explanatory power of book-to-market. With that said, many of the leading quantitative investment firms (such as AQR, BlackRock, Bridgeway, Dimensional and RAFI) have added additional metrics beyond B/M to the construction rules of their value portfolios, metrics such as the ones used by Choi, So and Wang. Others have also begun to make the type of adjustments to book value that Choi, So and Wang suggested. It seems highly likely that we will see more such adjustments made in the future.
The information presented herein is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Certain information may be based on third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Performance is historical and does not guarantee future results. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth® or Buckingham Strategic Partners® (collectively Buckingham Wealth Partners). LSR-21-106
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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