Value as a factor as well as a style of investing is widely covered in academic research and literature. Some seminal work
demonstrating the Value Effect was conducted by Fama and French, La Porta et al (La Porta et al., 1997, #) and Lakonishok et al (Lakonishok et al., 1994, #), among others.
Fama and French used Book Value/Market Value (B/M) to rank securities by relative valuation. This was used to create a High Minus Low (HML) portfolio, which bought the stocks with the highest B/M ratios and simultaneously shortsold those with the lowest (Fama & French, 1992). Their results showed that, on average, the HML portfolio generated positive returns. In general, the returns of the HML portfolio demonstrated that stocks with B/M ratios outperformed those with lower ones. This seminal study testified to the Value Effect, which is defined as the propensity of Value stocks (i.e. stocks that trade at a discount to their intrinsic value) to outperform those that are overvalued.
Lakonishok et. al (1994) (Lakonishok et al., 1994, #) also ranked stocks according to their B/M ratios, with the top 10% companies labelled as Value stocks, with the bottom 10% considered Glamour/Growth stocks. The results of their analysis echo the findings of Fama and French and once again, on average, value stocks outperform growth stocks.
The study conducted by La Porta et al (1997) (La Porta et al., 1997, #) depicted that on average Growth stocks underperformed Value stocks during earnings announcements, further illustrating the Value Effect. This observation was sought to be explained as the result of over-optimism about the growth prospects of Growth stocks and under-optimism about the prospects of Value stocks. The negative surprise in the announced earnings of Growth stocks and positive surprise in those of Value stocks appears to be the primary reason for the performance gap.
These empirical studies suggest that Value stocks tend to generate superior returns over long periods of time, since that allows the market to eliminate biases and price these securities correctly. However, it is imperative to note that irrationalities may persist for extremely long periods of time, reducing the efficacy of the Value factor.
Over the years, there has been a lot of research on how to exactly define value. For a very long time, Price-to-Book ratio or the inverse of it, the book value to market value was considered the ideal measure to define value. As time passed, new definitions for value emerged and were used by researchers and academicians. The most popular of these are explained in detail in this section. Each measure can be used and interpreted in multiple ways. Measures for a company can be compared with their own historical values or used for comparison to sector and industry peers.
Commonly used ratios to measure relative under/overvaluation:
- Graham number
- Price-to-Book value (P/B) Ratio
- Price-to-Earnings (P/E) Ratio
- Price-to-Sales (P/S) Ratio
- Price-to-Free Cash Flow (P/FCF) Ratio
- Dividend yield
- Enterprise Value to Earnings Before Interest Tax Depreciation & Amortised Expenses (EV/EBITDA) Ratio
We start with the measure of value explained by Benjamin Graham in his book ‘The Intelligent Investor’. It is popularly known as the Graham Number and calculated as,
- Earnings per share (EPS) is calculated as a company's net profit divided by the number of outstanding shares of its common stock.
- Book value per share (BVPS) is calculated as the equity available to common shareholders (also known as Book Value of Equity or Common Shareholders’ Equity) divided by the number of common shares outstanding. This figure represents the minimum value of a company's equity (based on its financial statements) and measures the book value of a firm on a per share basis.
The number of 22.5 reflected Benjamin Graham’s belief that typically, the Price to Earnings (P/E) ratio should not exceed 15 and the market price should not be higher than 1.5 times the last reported BVPS. Multiplying these two ratios must result in a value of 22.5 or lower, implying that a lower P/E ratio could allow room for a higher Price/ to Book value (P/B) ratio and vice versa. While any stock price below the Graham number is considered undervalued and worth investing in, a derivative of this number can also be used to rank stocks on a relative basis.
Price-to-Book Value (P/B) Ratio:
The Book Value of a company, commonly referred to as Book Value of Equity (BVE) or Common Shareholders’ Equity (CSE), is the total value of the company’s equity that is attributable to its shareholders. The BVE is calculated using the company’s reported financial statements. The P/B Ratio is calculated as,
P/B Ratio = Current Market Price per share (CMP) / Book value per share (BVPS)
BVPS = BVE / Total number of shares outstanding and
BVE = Net Assets = Total assets - Total liabilities
A company’s P/B Ratio can be compared to its stock price in order to determine the over or undervaluation of the company’s stock. It can also be compared to its own historical value or with those of the industry and sector the company belongs to. To get a wider perspective, it can also be used to contrast with P/B Ratios of broad market indices viz. Nifty 50 and/or BSE Sensex.
Price-to-Earnings (P/E) Ratio:
The P/E ratio is another valuation ratio that measures the price of a company's common stock as a multiple of its earnings per share (EPS). Like the P/B Ratio, it can be used as an absolute or relative measure. It is a very popular measure and is most widely used for determining the relative valuations. It is calculated as,
P/E Ratio = CMP / EPS
EPS = trailing twelve month profit / Total number of shares outstanding
The P/E ratio can be interpreted as the number of years that it would take for an investor to recover the value of the current share price based on the company’s current profits For instance, if the CMP of a company’s share is Rs. 400 and its EPS is Rs. 16, its P/R ratio would be 25 (400/16). This suggests that if the company continues to earn Rs. 16 per share every year, it would take 25 years for the accumulated earnings to equal the CMP. A lower P/E Ratio implies a shorter time period and is preferred to those that may take longer.
Another measure that is frequently used and can be easily derived from the P/E ratio is Earnings Yield (EY). EY is the inverse of the P/E Ratio and can be used for an easy comparison with yields prevailing in the bond market. This ability to be used for cross-asset comparisons makes the P/E Ratio a powerful measurement device.
Price-to-Sales (P/S) Ratio:
The P/S Ratio is calculated as below
P/S ratio = CMP / Revenue per share
Revenue per share = trailing 12 month revenues / Total number of shares outstanding
It is a comparison between the market capitalization of a company with its total revenues. A low P/S Ratio may imply that a company is attractively valued compared to those with a higher P/S Ratio. Since it uses sales revenues as an input, it is commonly used for early stage companies where profits are absent or those in which the impact of business cycles is very pronounced making profits volatile.
Price-to-Free Cash Flow (P/FCF) Ratio:
P/FCF Ratio compares the CMP of a company’s shares with its Free Cash Flow (FCF) per share. FCF differs from total cash flow which refers to both operating and non operating cash generated by a business, while FCF is calculated by subtracting a company’s capital expenditure from the cash generated from its operations. A company with persistent negative FCF relies on financing activities to fund itself. The P/FCF ratio is calculated as follows
P/FCF = CMP / FCF per share
FCF = Trailing twelve month cash from operations - Capital expenditure and
FCF per share = FCF / Total number of shares outstanding
FCF can also be perceived as the actual amount of cash available for funding non-asset growth activities and/or distributions to its debt and equity holders. Since the P/FCF Ratio also uses trailing annual numbers it can be seen to represent the number of years of FCF needed to recover the CMP. It follows that a lower P/FCF ratio is preferred to a higher one.
Dividend is the amount distributed by the company to its shareholders. It is typically a portion of the profits earned by the company in a defined period, though companies can also distribute dividends from earnings of previous periods in the interest of consistency. Dividend yield is calculated as follows
Dividend yield = Annual Dividends Per Share (DPS) / CMP
DPS = Trailing twelve month dividend / Total number of shares outstanding
A higher Dividend Yield is considered better than a lower one. Dividend Yield can be used in both, absolute and relative forms for decision making. The inverse of the Dividend Yield, the Price-to-Dividend (P/D) can also be used
Enterprise Value to Earnings Before Interest ,Taxes, Depreciation, and Amortised Expenses (EV/EBITDA) Ratio:
The EV of a company is the total value of a company irrespective of the manner in which it is financed. It is the sum of the market values of a company’s equity and debt, adjusted for non-controlling/minority interests and available cash balances and liquid investments (eg. marketable securities).
EBITDA represents the operating earnings of a company before the deduction of non-cash charges like depreciation. It is deliberately calculated before interest costs since the part of the capital financed by debt is included in the EV. Similarly, it is deliberately calculated on a pre-tax basis to allow for easy comparison of businesses across companies with different tax statuses.
Since like other parameters, EBITDA is calculated on an annual basis, the EV/EBITDA Ratio represents the number of years it would take for the company to recover its EV from the EBITDA generated by it. It is computed as follows
EV/EBITDA Ratio = EV / EBITDA
EV = Market capitalisation + Total long term & short term debt - cash and cash equivalents
EBITDA = Earnings Before Interest and Tax (operating profit) + Depreciation & Amortisation.
The EV/EBITDA ratio is not suitable for analysing companies in the financial services (particularly lending companies) since interest expenses are an integral part of the operating expenses of such firms.
The aforementioned ratios are some of the most widely used metrics for gauging relative valuation of stocks i.e. how overvalued or undervalued a stock is in relation to other stocks. This relative value can be evaluated by comparing these metrics with the corresponding metrics of its industry and/or sector counterparts, by comparing it with industry/sector averages, or by comparing the multiple with the corresponding multiple for a broad market index (viz. Nifty 50, Sensex etc.).
It is always advisable to gauge the relative attractiveness of a security by comparing a number of its valuation multiples with that of its competitors or industry average multiples, as opposed to solely making the decision based on the relative overvaluation or undervaluation manifested by a single multiple.