A study shows that a fundamental ratio based on intrinsic value can outperform traditional valuation metrics in predicting stock returns, especially in low-interest-rate environments.

A team from The Applied Finance Group and the Swiss Finance Institute analyzed U.S. stock data from 1999 to 2023 to understand the underperformance of traditional value investing strategies. They proposed using a ratio based on intrinsic value instead of book value, as the latter tends to focus on current assets while ignoring a company’s potential future growth. Their intrinsic-value-to-market ratio, on the other hand, factors in both future profits and company-specific risks, offering a more comprehensive view of a company’s value.

The analysis revealed that traditional metrics like the book-to-market ratio [the inverse of the price-to-book-value (P/B) ratio] have struggled to identify undervalued stocks, particularly with the rise of growth-oriented companies and persistently low interest rates. In contrast, portfolios based on intrinsic-value-to-market ratios performed significantly better, with 56 basis points (bps) of excess return for large stocks (represented by the Russell 1000 index) and 60 bps of excess return for small stocks (represented by the Russell 2000 index).

The research team concluded that intrinsic value models are better suited for current market conditions, where growth and future profits play a crucial role. They recommend that investors move away from traditional valuation metrics, which are less effective in low-interest-rate environments, and instead adopt intrinsic value ratios to improve stock selection and performance.

For investors, this study emphasizes the importance of adapting stock evaluation strategies to account for future growth and market risks.

Source: “Intrinsic Value: A Solution to the Declining Performance of Value Strategies,” by Derek Bergen, Francesco Franzoni, Daniel Obrycki and Rafael Resendes; July 2024.

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