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Top value ratio?

What do investors really want? An infallible yardstick to measure the true value of a stock would be nice.

Sadly, no such magic yardstick exists. But a handful of classic value measurements have demonstrated their ability to steer investors to market-beating opportunities over the past several decades.

These measurements of a stock's value take the form of ratios that compare the share price to underlying fundamentals. To see how eight different ratios have stacked up over the years, I turned to James O'Shaughnessy's book What Works on Wall Street, which offers a wealth of historical information on how various strategies have performed.

Some of the ratios I examined may be new to you. Here's the roll call:

The most popular yardstick for assessing a stock's value is the humble price-to-earnings ratio (P/E). It compares a stock's price to its earnings over the last 12 months. Sensible investors prefer to buy lots of earnings power for a low price, everything else being equal.

Next on the popularity scale is the price-to-book-value ratio (P/B), which measures how expensive a stock is compared to its net assets (assets less liabilities). This ratio is beloved by academics and it is a stalwart among value investors.

Third up is the price-to-sales ratio (P/S), which focuses on how the share price compares to revenue. Essentially, it tries to find companies that have lots of sales in comparison to their market value.

The price-to-cash-flow ratio (P/CF) compares a firm's price to its net operating cash flow, which Mr. O'Shaughnessy defines as net income plus depreciation and other non-cash expenses. It tends to be a better measure of a firm's cash-generating ability than earnings.

A closely related measurement is the price-to-free-cash-flow ratio (P/FCF). Free cash flow is net operating cash flow minus capital expenditures and dividends. It's an estimate of how much money a firm can distribute to shareholders without being forced to burn the furniture - or, less flippantly, how much a company can pay its shareholders without having to run down its machinery, offices and other productive assets.

The last three ratios use two accounting measures that are popular among analysts. The first measure is enterprise value (EV), which reflects the market value of a business including both equity and debt, while adjusting for cash. It estimates what a private buyer might have to pay for a firm while settling its debts at the same time.

The second measure is the awkwardly named 'earnings before interest, taxes, depreciation and amortization' (EBITDA). It's a rough measure of a firm's operational profitability independent of its capital structure.

EBITDA allows you to compare a firm that finances itself with lots of debt but little equity against a company that relies largely upon capital put up by shareholders, with next to no debt in the mix. Less generously, some refer to EBITDA as 'earnings before the bad stuff' because weak debt-laden firms often emphasize it rather than overall profits.

Enterprise value and EBITDA are used in the last three ratios, which are analogous to several of more common ratios. In these ratios enterprise value replaces price and EBITDA replaces earnings. For instance, EV/EBITDA is similar to P/E, EV/S is like P/S, and EV/CF is a close cousin of P/CF.

Mr. O'Shaughnessy studied how these ratios have performed as a stock-picking tool. Using each ratio, he sorted the universe of large U.S. stocks into 10 groups called deciles. He then tracked the groups for a year and repeated the process to see how stocks that ranked particularly high or low on the ratio performed.

You can see a summary of his results in the accompanying table. It shows the average annual performance, relative to the overall market, of the top 10 per cent of stocks and the bottom 10 per cent of stocks, based on each ratio, from Jan. 1, 1964 to Dec. 31, 2009.

The Value of Ratios: Average annual return relative to the market
Ratio Highest Ratio Decile (pp) Lowest Ratio Decile (pp)
EV/EBITDA -5.1 +3.7
P/E -3.6 +3.4
P/CF -3.9 +3.4
EV/CF -2.0 +2.9
P/B -1.4 +2.8
EV/S -5.7 +2.5
P/FCF -2.5 +2.0
P/S -5.5 +1.3
Data Source: What Works on Wall Street, 4th ed., pp: percentage point

The results are clear: You would have done well by buying stocks with low ratios, no matter which yardstick you chose.

Stocks with low EV/EBITDA ratios fared the best. They beat the market by an average of 3.7 percentage points a year. On the other hand, the low P/S group only outperformed by 1.3 percentage points a year. But whichever ratio you choose, low ratio stocks did well.

In contrast, high-ratio stocks hurt returns. For instance, the high EV/S group trailed the market by a whopping 5.7 percentage points a year. So, think twice before buying such stocks.

A note of caution, though. How each ratio performs tends to change over time. For example, low P/S stocks used to be Mr. O.Shaughnessy's favourite but they did not do well in the 2008 crisis. I fully expect to see the relative ranking of the ratios to shift when the next edition of What Works on Wall Street is published.

First published in the Globe and Mail, October 29 2012.

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