Many investors look at the price-to-earnings (P/E) ratio when deciding whether or not to buy a stock. They often believe that a low P/E ratio identifies value while a high P/E ratio indicates a stock should be avoided. Applying a test to identify value makes sense since buying undervalued stocks increase the probability an investment will be successful. But many investors fail to consider whether or not the P/E ratio is the best test for value. They might be relying on the P/E ratio just because it is popular and widely available.
Researchers have actually looked at the question of which metric is the best one for years. Many of the studies are buried in academic journals and largely inaccessible to individual investors. The articles themselves can be dense reading with advanced math that proves the results have a degree of statistical significance, but can be difficult for individual investors to understand.
Despite the difficulty of accessing the data, these results seem like that should be able to help individual investors find stocks that are likely to outperform the broad market. One of the most comprehensive and accessible studies, “Analyzing Valuation Measures: A Performance Horse-Race Over the Past 40 Years” was published in the Journal of Portfolio Management. This is a “practitioner’s journal” that emphasizes usability rather than obscure theoretical results.
In this paper, Dr. Wesley Gray and Dr. Jack Vogel focused on five indicators:
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- P/E ratio
- Earnings before interest, taxes, depreciation and amortization (EBITDA) to Total Enterprise Value (EBITDA/TEV).
- Free Cash Flow to Total Enterprise Value (FCF/TEV).
- Gross-Profits to Total Enterprise Value (GP/TEV).
- Price-to-book (P/B) ratio
The P/E ratio compares the stock price to earnings per share (EPS) and makes it possible to quickly compare the degree of value different stocks offer. A P/E ratio of 10 indicates investors are paying $10 for each $1 in earnings, while a P/E ratio of 20 indicates investors are paying twice as much for each dollar of earnings. All things being equal, the stock with the lower P/E ratio should be the better investment.
EBITDA/TEV is a metric favored by investment bankers. EBITDA is a measure of owners’ earnings since owners make decisions that affect the amount of interest and taxes a company pays. Depreciation and amortization are non-cash charges and management decides how to allocate that cash. TEV includes the value of any loans or bonds outstanding and recognizes the total value of the company. This is a more comprehensive ratio than the P/E ratio.
FCF/TEV is based on the cash management can use to reinvest in the business or to reward shareholders with dividends and share buybacks.
GP/TEV is a ratio that decreases the impact of accounting charges and various accounting assumptions on the company’s cash flow. GP is a line item near the top of the income statement and is not subject to adjustments like FCF or EPS are.
The P/B ratio measures how investors are valuing the company’s assets. Book value changes slowly and is less erratic than EPS. Book value also at least partly measures the impact of management’s decisions on capital allocation.
Before turning to the research, it’s important to determine what your goal as an investor is. If your goal is simply to avoid losses, any value investing strategy could be helpful. Over the long term, most value investing strategies have been shown to deliver positive results if they are followed with discipline. In the long run, the research generally concludes that any of these measures can beat the market, at least sometimes. If your goal is to use the best ratio, you may be disappointed by the research.
The truth is that no indicator will be the best tool to use all of the time. Researchers usually complete tests using decades worth or data. Their conclusions will include a summary based on all of the available data even if an indicator underperforms for several years during the test period. For example, value stocks underperformed for most of the late-1990s. The chart below shows Warren Buffett’s Berkshire Hathaway (NYSE: BRK.A) struggled while the Nasdaq 100 index soared at that time.
Analysts at the time questioned Buffett’s skill, speculating that he was unable to adapt to the new environment as the Nasdaq 100 jumped more than 145% from June 1998 to February 2000. Meanwhile, Berkshire was down 44% as Buffett underperformed by an incredible 189% over that time period. This may be the most dramatic example of value’s underperformance but demonstrates the importance of focusing on the long term. Since the internet bubble popped, Buffett has outperformed the Nasdaq 100 index.
To study the long term, Gray and Vogel’s article looked at the time period from July 1971 through December 2010, 39 years or about the length of time many investors are active in the markets assuming they open a retirement account in their 30s. They created a portfolio consisting of the 20% of stocks offering the best value. For the P/E ratio, for example, they measured the performance of the 20% of stocks with the lowest P/E ratios. The results of their analysis are summarized below.
EBITDA/TEV was the winner in this test. But, the other indicators also did well. As you can see from the chart, each of the value metrics outperformed the stock market over this time. However, this is just one time frame.
Gray and Vogel recently updated their work, looking at the five-year period that followed the publication of their results. That test is summarized in the next chart.
Here the results are less encouraging. FCF/TEV was the winner this time. For that five-year period, EBITDA/TEV, the winning ratio in the long-term test, ranks last. It’s also important to note that two of the metrics failed to beat the market over the shorter timeframe.
Before reaching a conclusion about value indicator is best, let’s look at another test Gray and Vogel completed which expanded the data set back to 1964 and runs through the end of 2015.
In the very long run, we again see that all of the value indicators beat the market. This time, the GP/TEV ratio has a slight edge in performance. In three different test periods, we have three different winners.
Instead of providing clarity and a simple answer to the question of which ratio is the best one, testing has added to the confusion. However, all of these tests provide us with two very important takeaways:
- Value works in the long run, no matter which metric is used to define value.
- It is important to remain focused on the long run and understand there will be periods of underperformance that can last for years.
Now, for the question of which metric to use.
Remember that in the long run, periods longer than five years, all of the value ratios beat the market. This means if you focus on the long term, you could use any metric. The P/E ratio is readily available and certainly provides results that are good enough. Its advantage is its simplicity. More complex indicators may decrease the risk of investing because they use more reliable data. EPS used in the P/E ratio can be manipulated by management and that means reported EPS may not match the reality of the business operations. The other indicators are less prone to manipulation but they are not 100% immune from management manipulation. It’s always best to use two or more indicators to minimize the risk that management is trying to deceive investors. Value and momentum, for example, work well together as we will explain in a future post.