Why this value-investing ‘buy’ signal is out of date

Marty Daks | Apr 25, 2017

Sections Accounting Finance

For stock investors hunting for securities that appear to trade for less than their intrinsic value, a high book-to-market price ratio is a “buy” signal. But this value-investing benchmark may need an update, potentially transforming the way investors calculate overvalued and undervalued stocks.

Book-to-market has been a staple of value investment strategies since at least 1934, when the late Benjamin Graham and David Dodd published the classic text Security Analysis. But research by Chicago Booth’s Ray Ball and Valeri Nikolaev, Dartmouth College’s Joseph J. Gerakos, and University of Southern California’s Juhani T. Linnainmaa suggests that the underlying reason investing in high book-to-market stocks earns higher returns on average is not that those stocks are undervalued. The researchers’ interpretation of the data is that book-to-market is actually a good indicator of profitability, and hence of factors, such as risk, that affect both profitability and average stock returns.   

In a traditional book-to-market price ratio, “book” is made up of two components: retained earnings and contributed capital, which is essentially the total value of stock that shareholders have directly purchased from the issuing company. Book, the numerator, is divided by market value (the number of shares outstanding multiplied by the stock price). In the simplest of value-strategy screens, if the ratio is above 1, the stock is believed to be undervalued and could represent a good deal. If the ratio is less than 1, the stock is thought to be overvalued.

The retained earnings-to-market ratio powerfully predicted future pricing, statistically significant up to 10 years into the future.

The researchers say there’s a weakness in the classic book-to-value computation, however: those key components of book together do not function as an accurate predictor of future stock prices. Instead, the researchers suggest stripping out contributed capital, leaving only retained earnings in the numerator.

Why? Research indicates that a ratio of earnings to market value is a likely proxy for expected stock prices. Retained earnings make a particularly good predictor because they include past earnings and also because “noise”—such as accounting accruals, and one-time items that typically reduce the informative value of bottom-line net income—largely averages out over time, which reduces its distortive effect on accumulated past earnings.

To test this, the researchers broke down traditional book value into its components, retained earnings and contributed capital. They developed a ratio—each component over market value—and utilized regression analysis to check how well each ratio predicted stock prices for New York Stock Exchange–listed companies. They find that the retained earnings-to-market ratio powerfully predicted future pricing, statistically significant up to 10 years into the future. In contrast, the ratio of contributed capital to market value exhibited a statistically insignificant relation to future pricing across all prediction horizons.

“Our evidence highlights the value of digging deeper into accounting numbers, whose components generally contain different information about the cross section of stock returns,” the researchers write.