As investors, we often talk about value. But, we don’t always agree on value. The disagreement could be as to whether a particular stock offers value or even exactly how we should measure value. In this article, we explore some of the common approaches to measuring value.
The most popular measure of value could be the price to earnings (P/E) ratio. However, now all companies have earnings. In the case of a company without earnings, the price to sales (P/S) ratio or the price to book (P/B) ratio could be more useful.
The most popular measure of value could be the P/E ratio. This was the ratio that was included in many newspapers when newspapers carried tables showing stock prices. Its widespread use could explain why it is popular.
P/E ratios are the ratio of the stock price to earnings per share. P/E ratios show how much investors are willing to pay for each $1 of earnings in the company. A P/E ratio of 40, for example, shows investors are willing to pay $40 for each dollar of earnings and a P/E ratio of 10 shows a willingness to pay just $10 for each dollar of earnings.
Some investors use an absolute measure of the P/E ratio to find value. They may believe only stocks with a P/E ratio below 15 offer value. This ignores the fact that ratios vary by industry. A utility grows slowly and will almost always meet that definition of value while tech stocks may not.
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P/E ratios also vary with interest rates. When rates are low, investors are generally willing to pay more for stocks and the average P/E ratio is likely to be higher than when interest rates are high.
Other investors use a comparative approach. They define value as a below average P/E ratio. This accounts for the differences in time and industry. That difference in P/E ratios over time can be seen in the long term of Microsoft (Nasdaq: MSFT) shown below.
To calculate the P/E ratio, a company will need to have earnings and that will not always be the case. This week, for example, more than 58% of all companies report no earnings for the past twelve months. Using the P/E ratio would limit your investments to a relatively small group of companies.
The P/S ratio shows the amount that investors are willing to pay for each dollar of sales. This is a more inclusive measure of value since more companies have sales than earnings. This week about 87% of all companies report some sales over the past twelve months. Using the P/S ratio could expand your investment options compared to the P/E ratio.
Studies also show the P/S ratio can be more profitable. For example, work by James O’Shaughnessy in What Works on Wall Street, analyzed a number of ratios based on a company’s financial statements, including the P/E, P/S and P/B ratios along with other less popular indicators.
To determine whether or not the company is undervalued, O’Shaughnessy found the P/S ratio worked best. However, this ratio can also vary over time.
The P/B ratio shows how much investors are willing to pay for one dollar of book value. It is possible for a company to have a negative book value. One way this could occur is if the company repeatedly loses money. Negative earnings are factored into book value by accountants.
That means this metric will also exclude a number of stocks. It turns out that the P/B ratio is usually more inclusive than the P/E ratio but less so than the P/S ratio. This week, about 19% of all companies reported a book value of 0 or less. It could simply be best to avoid companies like this until they report some value.
The next chart shows the expected pattern of variance with time.
This chart also shows an important pattern. High values of fundamental ratios are often seen in bull markets and low values of the ratios are often seen in bear markets.
As to the question of which ratio is the best to use, it is important to note that all tend to move in a similar pattern. This is shown in the next chart which includes all three of the ratios.
Since the general direction of the trend will be the same, that indicates any of the ratios could be useful. Another factor pointing towards that conclusion is the fact that the ratios tend to be high or low, relative to their average, at about the same time.
The fact that they move in such a similar pattern means they could be thought of as interchangeable. That leads to the question of which one is best.
As noted earlier, quantitative testing completed by O’Shaughnessy demonstrated that the P/S ratio did the best job. By this we mean that the P/S ratio offered the most predictive insight.
O’Shaughnessy sorted all stocks by value. He found that stocks with low P/S ratio, on average, delivered the best performance in the future compared to the P/E ratio and other fundamental measures. This is one way to evaluate the ratio’s predictive ability and is one test that does matter to investors.
Another advantage of the P/S ratio is that it is the most inclusive of the common fundamental metrics. It includes more stocks than the P/E ratio or P/B ratio on the list of potential investments.
This Leaves The Question Of How To Measure Value
One approach that could be most useful is to compare the stock’s ratio to the industry average or the stock’s own long term average. Either approach will show whether the value is higher or lower than average.
Perhaps the best approach would be a combination of the two comparisons. For example, an investor could limit the search for value to stocks that are currently trading with a P/S ratio below the industry average and below the average ratio of the last 5 years for that stock.
This week, about 17% of publicly traded companies passed that screen. This should provide a sufficient starting point for investors seeking to build out a value based portfolio.
The second step could be to find stocks with better than average relative strength. This is the approach O’Shaughnessy applied and found to deliver the best performance. Requiring stocks to be in the top half based on performance over the past six months narrowed the list to just 5.6% of publicly traded stocks.
From here, an investor could add additional criteria such as requiring the company to be growing sales over the past year or even in each of the past five years. Or, an investor could scan charts of these stocks to find technical patterns of interest.
The possibilities are, in all honesty, endless. However, any approach is likely to meet with success if it begins with value and is applied consistently over the long run.
No Matter How It Is Measured, Value Is At The Heart Of Many Disciplined Trading Strategies.
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