Fixing the poor performance of the book-to-market ratio

While the research, commentary and speculation about the failure of value factor strategies over the last decade or two continues along a number of avenues, we haven’t yet seen a movement back towards fundamental analysis or a discounted cash flow (DCF) approach. In this paper, the authors argue for just such a solution. It is a good idea, and the analysis supports the supposition. Read on.

Intrinsic Value: A Solution to the Declining Performance of Value Strategies

• Derek Bergen, Francesco Franzoni, Daniel Obrycki and Rafael Resendes
• Working Paper
• A version of this paper can be found here
• Want to read our summaries of academic finance papers? Check out our Academic Research Insight category.

What are the research questions?

1. Is calculating intrinsic value (IV/M) a better approach to building value strategies relative to using the book-to-market ratio?
2. How does a sustained period of low interest rates fit in to the story?

What are the Academic Insights?

1. YES. The results presented in Figure 1 comprise the majority of the evidence in favor of the IV/M hypothesis. The empirical analysis confirms that the intrinsic value to market (IV/M) ratio outperforms the book to market ratio in forecasting stock returns. Long-short portfolios based on the IV/M ratio generated positive excess returns, while similar portfolios constructed on the basis of the book to market ratio did not. Specifically, the alpha of the IV/M-based portfolios beat that of the book to market portfolio by 56 bps. The alpha for the book to market portfolios was effectively zero. While Figure 1 is limited to CAPM risk adjustments, the results were robust to the risk model including the CAPM, and Fama-French 3- and 5-factor models. A bit more on how portfolios were constructed: Over the period 1999 to 2023, within the US universe, stocks were sorted by book to market and IV to market, splitting the sample at the median of the distributions of these two variables. For both value and growth universes as indicated by the book to market ratio, only those with the highest IV to market produced positive and significant excess returns. Overvalued stocks lagged or failed to produce an excess return regardless of the risk adjustment made. If intrinsic value is a better indicator, the advantage is likely due to its unique ability to capture future growth prospects, an aspect of pricing not captured by traditional valuation ratios.
2. The logic requires a return to traditional fundamental analysis and the basics of discounted cashflows with all of its intricacies. The argument goes something like this: as interest rates decrease, the present value of future cashflows becomes a more significant portion of a stock’s total intrinsic value. The significance becomes even larger as interest rates decline dramatically and persist for sustained periods. In contrast, the book to market ratio largely reflects the value of existing cashflows or assets. That condition along with the shift in economic conditions makes simple book to market ratios increasingly less accurate in predicting stock returns. As you may have guessed, the evidence presented in this study documents the correlation between the book to market and IV/M rankings has decreased over time, and especially so when interest rates are low. The authors conclude that the need to explicitly capture the impact of expected cashflow growth has become an issue for value strategies especially given the sustained decline in interest rates. Those two conditions have exacerbated the shortcomings of traditional valuation metrics like the book to market ratio.

Why does it matter?

The authors effectively argue the case for intrinsic value and DCF based approaches to building Value factor strategies. The traditional value measures, especially the book-to-market ratio, are described as ineffective in today’s market environment. Within and under a sustained low interest rate environment, users of a simplistic book-to-market indicator have experienced disappointing excess returns. Why so? Again, the authors persuasively argue that firm fundamentals are more accurately captured by intrinsic value which in turn is robust to current and an historically low interest rate market environment. It remains to be seen if newer measures of value proven to be superior to the book to market behave similarly. Perhaps the authors of this study will apply their particular insight to other commonly used value metrics?

The most important chart in the paper

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained.  Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.

Abstract

The paper proposes to use intrinsic value as an alternative measure of fundamentals in predicting stock returns. To construct intrinsic value, we add the book value of equity to the discounted sum of future economic profits and use a firm-specific discount rate that accounts for size and leverage. The intrinsic value-to-market (IVM) ratio has strong forecasting power for the cross-section of stock returns even in the last two decades, where the book-to-market ratio and similarly constructed price multiples fail to predict returns. In particular, the CAPM alpha of a long-short portfolio of large stocks based on the IVM ratio is 56 bps per month between 1999 and 2023, while the alpha of the corresponding portfolio based on the book-to-market ratio is indistinguishable from zero. We relate the difference in performance between the two approaches to the fact that book value better approximates the true intrinsic value of the firm only when future economic profits are not a significant component of firm value. In particular, as discount rates decline, the component of firm value due to future economic profits becomes more relevant and the link between book value and intrinsic value becomes more tenuous. These findings have significant implications for investors and financial analysts seeking to refine stock valuation methodologies in response to evolving market conditions and macroeconomic regimes.