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Even as far back as the Great Depression, investors have used the book-to-market ratio to find bargain stocks. But new research from Harvard Business School’s Charles CY Wang, Glenn and Mary Jane Creamer, associate professor of business administration, suggests that it has become so disengaged from modern research and intellectual property-driven economy that it not accurately reports supposed price stocks.
Book-to-market ratios are used by investors and are relied on by major stock indexes and institutional investors to identify possibly cheap stocks. However, Wang and colleagues discover that the book-to-market ratio’s association with other valuation ratios has decreased from 75% to 45% after analyzing thousands of firms over nearly 40 years. While other valuation metrics still reliably anticipate future returns and growth, this one has lost its predictive power.
“Institutional investors are “still relying on an increasingly flawed measure for identifying value stocks,” according to the article.”
Wang’s findings suggest that investors may be placing too much faith in a once reliable tool that is now not paying off as well, at a time when some question if the stock market is overvalued and may face some turbulence as the economy continues its recovery. So, if you want to find promising stocks in the future, you might have to put in a little extra effort.
When asked about the efficiency of the market, Wang stated, “We are taught that brilliant individuals are working in the market, and therefore we can expect the needs to be reasonably practical, but index providers and institutional investors still rely on flawed metrics that are unable to identify high-value stocks accurately.
Go with the Book: Valuation Ratios and Stock Returns was written by Wang, Ki-Soon Choi, and Eric C. So of the Massachusetts Institute of Technology’s Sloan Faculty of Management.
Analyzing Stock Prices in Further Detail
Compares the value of a corporation to its capitalization. The book value of a firm is calculated by taking the total value of all of its assets, such as its property, machinery, and patents, and subtracting the total value of all of its liabilities, such as its debt. The market value of a public firm is the value of all of its outstanding shares multiplied by the current price of a claim on the stock market. When the book-to-market ratio of a stock is less than 1, for instance, that supply is deemed inexpensive and should imply higher future returns.
The authors used data from Standard & Poor’s Compustat, CRSP, and Thomson Reuters S12, mutual fund holdings, to determine the predictive power of the ratio. Next, they checked stocks trading on the New York Stock Exchange, Amex, and NASDAQ with positive book values.
“Compares the value of a corporation to its capitalization.”
Wang and his colleagues analyzed 84,837 data points from 1980 to 2017 from businesses that had at least ten months of measurements. Financial firms and institutions with stock prices lower than $5 were excluded from the analysis.
Four alternative valuation ratios (sales-to-price, gross profit-to-price, net-to-price payments, and a composite balance) were then used to evaluate whether the book values of companies matched or exceeded their market values. While the book-to-market balance fared well in predicting stock returns in the 1980s and 1990s, the researchers discovered that it did not maintain its strength between 2005 and 2017, while the other ratios did. Continued to perform their current tasks.
In contrast to other valuation metrics, book-to-market has lost its capacity to assist investors in picking bargain businesses, shocking Wang.
The Problem with the Metric
The metric’s decreasing validity over time may be attributable to this. They believe it’s because of the shift to a knowledge-based economy.
Researchers have found that during the past 10–15 years, intangible asset investments (such as those made in knowledge and organizational capital development, intellectual property, brand recognition, and customer loyalty) have become increasingly crucial to businesses. However, under U.S. GAAP, investments like this are not considered assets but written off against income. As a result, the value of the company’s equity on the books will decrease due to these investments.
“You can and will figure out a solution to every problem if you have a firm grasp of accounting.”
“For IT or healthcare companies, market prices can seem high relative to book value. These companies have made substantial investments in R&D, which probably have economic worth, the market may reason. It’s simply that they don’t show up on the balance sheet,” Wang added. Because of these anomalies, comparing the book-to-market ratio among companies that invest differently or over time can be challenging.
The researchers argue that share buybacks and dividends diminish cash flow and stock’s book value and skew the book-to-market ratio. It is no surprise that the increased popularity of buyouts and the importance of intangible assets in recent years have coincided with the deterioration in the usefulness of the book-to-market ratio as a return forecast.
That’s why, as Wang put it, “ultimately, we want to use these indicators to assist us in choosing stocks that are most likely to deliver strong returns.”
As An Investor, What Steps Should You Take?
Wang suggests that, in light of these shifting conditions, investors conduct in-depth intrinsic valuation analyses or look beyond traditional valuation ratios. Specifically:
Think about a multitude of different measurement tools. Value investors who use valuation ratios to pick stocks should look at a broader range of measures, including sales/price, gross profit/price, net payouts/price, and profit/price. With this method, an investor would have a better idea of whether or not a company is reasonably priced.
Think outside the box of ratios. There is no more theoretically sound way to evaluate a store than by contrasting its intrinsic value with its current market price. A discounted cash flow analysis should be considered to determine the stock’s worth.
Wang argued that those who construct stock indexes and the funds that follow them should reevaluate their criteria for what constitutes a value stock.
When determining which firms should be included in its Russell Value 3000, Russell Value 2000, and Russell Value 1000 indices, for instance, FTSE Russell, the most prominent provider of style indexes in the United States, assigns book-to-market ratios a 50% weighting. The authors suggest ditching the book-to-market balance to create more accurate value equities portfolios in favor of more applicable valuation criteria.
“All hope is not lost,” Wang says. We aren’t advocating for the complete disregard of accounting as a useless activity. In reality, the takeaway here should be that you’re getting a real education in accounting. You can and will understand how everything fits together after you learn to account.