Valuation ratios

When you take two fundamental measures of a stock or business and divide one by the other you get a financial ratio. A valuation ratio is a financial ratio that directly relates to the market price of the stock or business. P/E is the price/earnings ratio, or the current market price divided by the trailing twelve months’ earnings. All else being equal (a condition that doesn’t usually hold), a stock or business with a lower price/earnings ratio than another is “cheaper”. This is because you’re “buying” the earnings of the business for a cheaper price.

The price/earnings ratio is the most commonly cited financial ratio because it’s one of the simplest to understand, use, and find. Selecting stocks based on low price/earnings ratio beats the market. Cameron Truong shows in this paper that if you divided the universe of stocks listed on the New Zealand stock exchange into five groups ranked by the lowness of their price/earnings ratio, the group with the lowest price/earnings ratio (the “best p/e quintile”) returned 18.81% per year from 1997 to 2007, and the “worst p/e quintile” returned -1.95%. Note that this is using backtested data, but forming a strategy that can be replicated going forward (ie, it’s not using future data to make current decisions to buy or sell, it’s using past data to make current decisions to buy or sell).

Results like this (although not of this magnitude) are generally repeated in all stock markets over time. Dr Truong has other papers showing the lack of efficiency in the NZ stock market. If this lack of efficiency is actually reality, it’s not surprising that such a simple strategy has positive abnormal returns.

One other very recent paper using more complete data from the USA is Analyzing Valuation Measures: A Performance Horse-Race Over the Past 40 Years. Wesley R Gray (check his blog and website) and Jack Vogel take five common financial ratios and backtest their performance over the last 40 years.

The five valuation ratios are:

• Earnings to market capitilisation (E/M)
• Earnings before interest and taxes and depreciation and amortization to total enterprise value (EBITDA/TEV)

• Free cash flow to total enterprise value (FCF/TEV)
• Gross profits to total enterprise value (GP/TEV)
• Book to market (B/M)

Here are their results:

The “CAGR” is the compound annual growth rate. Gray and Vogel divide into quintiles as well and find that the “best quintile” of EBITDA/TEV (on an equal weighted basis, rather than weighed by market cap) returns 17.66% as compared with the “worst quintile” of 7.97%. So if you just ranked all the stocks every year from 1970 and bought the 20% that were “cheapest” on the EBITDA/TEV metric, you would have returned 17.66% on average over 40 years. If you started with $10 000, you would have $6 685 805 after 40 years. Backtesting has some problems, but the paper corrects for the most glaring ones.

Other “value investing” metrics also have abnormal positive returns (the best kind of abnormal returns) but EBITDA/TEV seems to be the most abnormal (and hence most positive).
Knowing this now, I would like to run Truong’s data through an EBITDA/TEV backtest. I emailed Dr Truong and got his data, but I’m not sure when I’ll find time to run the test (plus I don’t have all the fancy software or any research assistants). If I get round to it I’ll post results here. It’s not directly relevant to the bookbookfund because we’re not investing in NZ equities, but I invest in some NZ equities on my personal account so am generally interested.

On the more general point of valuation metrics, some of the investments in the bookbookfund are chosen because of their high valuation ratio rank in the universe of US stocks. Two of those currently in the portfolio are Dell and Microsoft. I may come back to one or both of those in a later post.