Time for a new measure of value

Investors pursuing a value strategy may be left selectively blind by traditional book-value calculations

Time for a new measure of value

For at least a decade, value stocks have generally not done as well as their growth-oriented counterparts. While some believe that history will repeat with a comeback for value, others are more convinced that it’s time to change how it’s measured.

“[A] growing percentage of companies’ market value now comes from intangible assets — things like patents, trademarks and research-and-development expenditures — that are either ignored in the book-value calculation or reflected inconsistently,” wrote Wall Street Journal contributor Mark Hulbert.

Citing data from Dartmouth College Prof. Kenneth French, Hulbert wrote that growth stocks — as represented by the 50% of stocks with the highest price-to-book ratios — have beaten value over the past decade by 1.9% on an annualized basis. In comparison, value stocks — the 50% of stocks with the lowest price-to-book ratios — outdid growth by 4.6 annualized percentage points.

“According to Ocean Tomo, an intellectual-property consulting firm, 84% of the S&P 500’s market capitalization now comes from intangible assets, up from just 17% in 1975,” he added.

In a 2016 book titled The End of Accounting and the Path Forward for Investors and Managers, professors from New York University argued that the “industrial-age treatment of intangible capital” under generally accepted accounting principles (GAAP) is leading to the increasing irrelevance of book value.

Baruch Lev, one of the authors, points out how GAAP requires companies that invest in developing intangible assets like their brand, a patent, or a process to count the investment as an expense; paradoxically, intangible assets that are bought and not internally generated are to be listed as assets on the balance sheet.

Others are not so quick count out the old way’s relevance. Kent Daniel, a finance professor at Columbia University and a former co-chief investment officer at Goldman Sachs, notes that the price-to-book ratio has never “captured the value of a firm’s growth prospects at all,” and that some researchers have found it useful in distinguishing companies with the most R&D spending — a significant category of intangible assets — from those with the least.

“Another clue that the price-to-book ratio may still be relevant comes when using it to forecast the S&P 500’s return over the subsequent 10 years,” Hulbert wrote. “Its record since 1975 has been better than it was over the prior five decades.”

One theory behind the recent lagging performance of value comes from an upcoming study in the Journal of Financial Economics. Ray Ball, an accounting professor at the University of Chicago and one of the study’s co-authors, explained that book value has two major components: contributed capital and retained earnings.

Contributed capital, or the sum of all past equity issuances from a company less share repurchases, has never had much predictive value, but its contribution to firms’ book values has been growing. Ball encouraged investors to focus more on retained earnings, saying that “a ratio of price to retained earnings per share remains as effective an indicator as ever in predicting stock returns.”

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