By Jack Forehand (@practicalquant) —
No investing factor has been maligned more than the Price/Book in recent years. In a period where value in general has performed very poorly, the Price/Book has struggled more than any of the other common value factors. When you couple that with the fact that the Price/Book’s failure to account for intangible assets makes its validity questionable in a world where more than 80% of assets are intangible, you have a perfect storm for investors challenging the long-term validity of the factor.
And when I say that investors have been questioning the Price/Book, I am not just referring to others. I am also referring to myself. I have talked often in my articles about the case against the Price/Book and why it may not work in the future like it has in the past.
But as we question the long-term validity of the Price/Book, I think all of us also need to dig a little deeper into why we are questioning it in the first place, and what it says about our own investing process.
Spreading Around the Scrutiny
I recently appeared on the Acquirer’s Podcast with Tobias Carlisle and during the interview Toby asked me a question that really got me thinking. He asked me why we all always tend to question the long-term efficacy of a factor like Price/Book when it is out of favor. I think that is a really important question.
It is no coincidence that the value metric that everyone is questioning the most right now is the one that has performed the worst in the past decade. I haven’t seen any articles challenging the PE Ratio. I have seen no takedowns of the Price/Sales. Everyone (myself included) loves EV/EBITDA so you don’t see much talk about its weaknesses. Maybe it is because those are better metrics (and you can certainly argue that based on long-term data), but it is also important to keep in mind that all of us tend to spend much more time scrutinizing things that aren’t working than things that are, and sometimes that can be a detriment to long-term performance.
Even return periods as long as a decade or more can have significant noise in them. The fact that the Price/Book has struggled in the most recent decade doesn’t tell us that it no longer works. Even though it may deserve the extra scrutiny it has gotten, it might make sense to also take a look at the other value metrics to understand their weaknesses.
So to make up for all the time I have spent scrutinizing Price/Book, I thought it might be useful to pretend that each of the other value metrics had been the worst over the past decade and to come up with the arguments against them as well.
The Weaknesses of Popular Value Metrics
Here are some arguments against the most widely used value factors:
Price/Earnings – Earnings can be subject to manipulation and accounting gimmickry. Also, all the price-based metrics don’t take debt into account like enterprise value based metrics do.
Price/Sales – How is it reasonable to evaluate a company without even considering if it makes money? Price/Sales treats a high margin company the same as a company that loses money. That doesn’t seem to make much sense, especially in a technology dominated world where the separation between low margin and high margin firms seems to be widening.
Price/Cash Flow – Although non-cash expenses may not involve the transfer of cash, there is a reason they exist. Excluding them in some situations can lead to a less clear picture of a firm’s business.
EV/EBITDA – Depreciation may be a non-cash expense, but assets require maintenance, and by adding it back this metric can favor
So if any of these metrics had been the worst performer in the past decade like Price/Book has, I could look back in retrospect and make a case why it shouldn’t be trusted. Some of these arguments are better than others and the argument against Price/Book may in fact be the strongest, but it is important to understand that no investment metric is perfect and all of the standard valuation metrics have their weaknesses. If any of the others were struggling as badly as Price/Book in the past decade, they might be seeing similar scrutiny.
And this idea doesn’t just apply to value investing metrics. Low volatility investing has certainly been hot in recent years, and it has long-term evidence to support it. But if it struggles in the next decade, we will all be asking ourselves whether it was reasonable to expect to get the same or greater returns than the market while taking less risk. And there are many other examples of the same thing.
None of this is to suggest that the Price/Book doesn’t deserve the scrutiny it gets or that is isn’t flawed. It does and it is. But all investing metrics are flawed in some way and the fact that all of us tend to give extra scrutiny to things that are out of favor may lead us to miss flaws in other areas of our investment strategy that have been working well in the short-term. Being willing to scrutinize your investment strategy is a great thing. It just shouldn’t always be poor performance that initiates the process.
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