In 1992-1993, Eugene Fama and Kenneth French published several academic papers that provided investing ideas that expanded on the classic Capital Asset Pricing Model (CAPM). They showed that over long periods of time, 90% of returns from diversified portfolios can be explained by 1) beta (the essential CAPM factor explaining excess portfolio returns over market returns), 2) valuation and 3) size. We recognize that no model is infallible and believe that human behavior is impossible to quantify. However, the Fama-French findings are extremely useful variables to use for screening potential investment candidates to include in a diversified portfolio. Below are the three value factors we consider in our investment decision framework.
Price-to-Book (P/B) ratio: This is the ratio of a company’s market value relative to its GAAP book value. Book value is found on a company’s balance sheet and represents the total value of a company’s assets minus the value of its debt and other liabilities. We focus on this metric when analyzing the value of a company. We prefer to invest in companies with low price to book ratios. Traditionally, growth stocks have high P/B ratios.
Price-to-Cash Flow (P/CF) ratio: The P/CF ratio is the ratio of a company’s market value to its operating cash flow per share. Operating cash flow (OCF), as the name implies, is the cash a company earns from its normal business operations. One standard definition: OCF = EBIT (Earnings Before Interest & Taxes) + Depreciation – Taxes. OCF is a good measure of the strength of a company. In theory, companies with a lower P/CF will tend to perform better than those with a higher P/CF as tghe market ultimately will recognize the company’s underlying strength. We prefer to invest in companies with consistent cash flow and solid cash flow margins. Growth companies frequently are relatively young and unestablished. As a result they may have little to no stable operating cash flow and correspondingly exhibit high P/CF multiples.
Price-to-Earnings (P/E) ratio: The P/E ratio is the ratio of a company’s market value to its net earnings per share. The P/E ratio is a widely known concept but we prefer the inverse ratio, the E/P ratio or earnings yield, for comparative analysis to bonds, REITs, preferreds and various arbitrage strategies. Again, typical growth companies are relatively nascent in existence and probably have nominal or no earnings resulting in high P/E ratios. Following simple math logic, a company that has a high earnings yield correspondingly must have a low P/E ratio.
Stocks with the best combined aggregate value factor have outperformed the broad market over the last 50 years.