An Alternative Measure of Value

A researcher suggests that a ratio of cash-based operating profitability to price is a better judge of whether a stock is undervalued or overvalued than traditional indicators.

In response to studies showing value investing strategies underperforming, Baolian Wang from the University of Florida proposed using a cash-based operating profitability-to-price (COP/P) ratio as an alternative measure of value. His research shows the indicator outperforming the more traditional price-to-book ratio, particularly over the 10-year period ending 2018.

The COP/P ratio is computed as operating profitability minus accruals divided by market capitalization. Operating profitability is calculated as revenue minus cost of goods sold and reported selling, general and administrative expenses; these expenses exclude research and development costs. Accruals are the change in accounts receivable plus the change in inventory and the change in prepaid expenses minus the changes in accounts payable, deferred revenue and accrued expenses.

Using U.S. stock returns over the period of 1963 to 2018, Wang found a strong positive correlation between a firm’s COP/P ratio and its subsequent returns. Sorting stocks into COP/P deciles, the excess returns of both equal-weighted and value-weighted portfolios increased as COP/P increased. (The value-weighted portfolio follows a weighting approach akin to a market-cap-weighted portfolio.) A hypothetical portfolio that buys stocks in the highest COP/P decile (stocks whose COP/P ratios rank in the top 10%) and shorts stocks in the lowest COP/P decile realized a monthly return of 1.080% for an equal-weighted portfolio in excess of the risk-free rate. For the value-weighted portfolio, the excess return was 0.909%. Moreover, Wang noted the stickiness of outperformance, with the same portfolio earning annualized returns of 13% on an equal-weight basis and 11% on a value-weight basis for at least five years after portfolio formation.

When it came to different size firms, the excess returns or “COP/P effect” was found to be applicable to various sizes. Although the effect is weaker among large firms than small, even among the largest firms analyzed, high-COP/P stocks continued to outperform low-COP/P stocks.

Wang proposes that many existing value signals are not nearly as effective in comparison to the COP/P ratio. For example, the book-to-market signal fails to predict returns in the post-1990 period and predicts returns negatively after July 2007, whereas the COP/P ratio more accurately matched actual returns even in recent years. One possible reason that the COP/P measure works better than book-to-market is that cash-based operating profitability is a better measure of firm fundamentals given the growing importance of intangibles.

Source: “A New Value Strategy,” by Baolian Wang; Warrington College of Business, University of Florida, January 2020.