Price to book ratio: stable and useful in screening for all stocks
According to Joao Toniato, Global and European Equity strategist, and Ken Lee, European Accounting and Valuation strategist from Barclays, using ratios that are not influenced by volatility of earnings revisions are more effective in screening for underpriced (value) stocks. Fama and French have determined in their Cross-Section of Expected Returns study that the price to book (P/B) ratio explains stocks returns better than any other financial ratio. Barclays back testing confirms this finding as it shows that stocks with a low P/B outperform stocks with a high P/B by 7% annualized over the last 10 years. Stocks with a low P/B ratio also returned 2.7% more than the market over the same period.
Investors must keep in mind the following when using a P/B screen:
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- P/B ratios can be influenced by accounting rules. For example, if balance sheets assets are overstated, equity will also be higher overstating the denominator and understating the ratio. However, P/B ratios are less exposed to earnings fluctuations driven by quarterly estimates showing in the price to earnings (P/E) ratio).
- P/B ratio screens may identify companies with a low return on equity (ROE). Investors should screen companies with a high ROE in addition to a low P/B, according to Barclays (NYSE:BCS). Goal is to avoid companies that have low P/B ratios simply because they are not generating returns. Combining low P/B ratio with high ROE filters results in excess annualized returns of 32.6% over the high P/B and low ROE screen and 13.6% outperformance against the market.
- Another complement to the P/B screen is dividend yield. Barclays (NYSE:BCS) analysts added high dividend yield to the low P/B and high ROE screen. Back tests showed that this screen outperformed the market by 19.5% over the past 10 years.
- P/B ratio screens can be used on both financial and non-financial stocks.
Price/cash flow: cash is king
Cash is king is one investor adage. Using cash flow from operations as a denominator avoids earnings fluctuations and influences of onetime items and takes into account items impacting costs and ability to collect, such as inventories and account receivables. When it comes to screening underpriced stocks, price/cash flow (P/CF) ratios outperform other measures such as P/E and P/B in Barclays back tests. Stocks with a low P/CF ratio outperformed stocks with a high P/CF ratio by 13.4% annualized and beat the market by 4.1% annualized over a 10 year period. Excess returns are over twice the ones generated by low P/E ratio stocks. Low P/E stocks outperformed high P/E stocks and the market by 5.9% and 2.4% annualized, respectively over 10 years.
Investors should consider the following when using a P/CF screen:
- Cash flow is volatile and portfolio turnover may be high when using this screen alone.
- P/CF ratio does not explain the drivers of a company’s return and the risks taken with generating returns. Companies with high leverage ratios, such as debt/equity, can be weeded out of the potential investment list as they are generating returns by using financing.
- Free cash flow yield helps in filtering out underperformers from the P/CF screen. Companies with high free cash flow yields outperformed companies with low free cash flow yields by a large margin (7% annualized over ten years). However, high free cash flow yield companies outperformed the market by only 0.1% over the same period.
- Using return ratios such as return on assets and return on equity improves the screen’s effectiveness.
- Caveat to this screen is that it cannot be applied to financial stocks.
Barclay’s analysts filtered stocks (excluding financial names) using low P/CF ratios, high return on assets (above market’s mean) and low debt/assets ratio (below market’s mean). This screen outperformed the Stoxx TMI ex-financials index, the market proxy, by 17% annualized over 10 years.