Recently, we implemented a new methodology for arriving at the A+ Value Grade. The change doubles the number of valuation measurements the Value Grade encompasses from three to six. This allows Value Grades to be assigned to an even broader range of companies.
We continue to use the price-to-book-value (P/B) and the price-to-sales (P/S) ratios, but we are now using the price-to-free-cash-flow (P/FCF) ratio instead of the price-to-cash-flow ratio. Also, three new valuation measures have been added: the price-earnings (P/E) ratio, the ratio of enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA) and shareholder yield.
To ensure the validity of the factors used for the revised Value Grade, we backtested the results of the new scoring system across all letter grades (A to F) for the period of 1998 through 2019.
Here are the results:
As we would expect, moving from Value Grades of F to D to C to B to A resulted in better cumulative returns for each higher grade. Even between Value grades of A and B, the higher letter grade outperformed the lower by more than a factor of four.
Here are the expanded valuation measurements used for the Value Grade taken from the Stock Evaluator page for Procter & Gamble Co. (PG):
The “Score” for each of the six valuations used for the Value Grade is the percentile rank for the company. So, for example, Procter & Gamble ranks in the 78th percentile for the price-to-sales ratio as of the close on Thursday, April 9. The PG column is the actual value for the company for each of the six valuations. So Procter & Gamble was trading at 63.3 times trailing earnings per share as of the close on April 9. The Sector Median column displays the median values for the company’s respective sector. In the case of Procter & Gamble, the median price-to-book ratio for the companies in its sector (consumer non-cyclicals) was 1.85 as of the close on April 9.
In another change for the Value Grade, the final letter grade is based on the percentile rank of the average of the six different valuation metric scores. For Procter & Gamble, the average score for its six valuation metrics is 82 as of April 9. Previously, that 82 was then used to arrive at the Value Grade. However, to have a more uniform distribution of letter grades, we now take the percentile rank of the average score. So Procter & Gamble’s average score of 82 ranks in the 97th percentile for all stocks in the A+ Investor universe as of April 9.
Price/Sales
Seeking undervalued stocks based upon the price-to-sales (P/S) ratio was first popularized by Kenneth Fisher in his 1984 book “Super Stocks.” Proponents of the price-to-sales ratio argue that earnings-based approaches to selecting stocks are inferior because earnings are influenced by many management assumptions trickling through the accounting books. Basing value relative to sales tends to be more consistent than basing value relative to earnings. Temporary developments such as costs incurred in the rollout of a new product or a cyclical slowdown can influence earnings more than sales, often leading to negative earnings. The price-to-sales ratio can provide a meaningful valuation tool when negative earnings render earnings-based models useless. Recent research indicates that using price-to-sales ratios may lead to better investment results than price-to-book-value ratios or price-earnings ratios.
The price-to-sales ratio is determined by dividing market price per share by the sales per share for the most recent 12 months.
Price/Earnings
The price-earnings ratio, or earnings multiple, is one of the most popular measures of company value. It is computed by dividing the current stock price by earnings per share for the most recent four quarters. It is followed so closely because it relates the market’s expectation of future company performance—embedded in the price component of the equation—to the company’s actual recent earnings performance. The greater the expectation, the higher the multiple of current earnings investors are willing to pay for the promise of future profits. If the market has low earnings growth expectations for a firm, or views earnings as suspect, it will not be willing to pay as much per share as it would for a firm with high and more certain earnings growth expectations.
The price-earnings ratio is determined by dividing market price per share by earnings per share for the most recent 12 months.
EV/EBITDA
The enterprise-value-to-EBITDA (EV/EBITDA) ratio helps to measure the value of a stock relative to its earnings potential. Many investors feel that a company’s enterprise value relative to its earnings before interest, taxes, depreciation and amortization (EBITDA) is a better way to measure company value than the price-earnings ratio alone. The ratio is neutral to the company’s capital structure and capital expenditures.
A company’s enterprise value represents its economic value, which is the minimum value that would be paid to purchase the company outright. Enterprise value is equal to the market value of equity (including preferred stock), plus interest-bearing debt, minus excess cash. Enterprise value takes into account both the market price of equity and the debt used to generate earnings. Companies with debt must pay interest on the debt and eventually pay off the debt. This makes the company’s true acquisition cost higher. Adding debt to market capitalization lowers the enterprise-value-to-EBITDA ratio, making a company less attractive. Excess cash is subtracted from enterprise value because the unneeded cash reduces the overall cost of acquiring a business. EBITDA ends up serving as an approximation of the firm’s operating cash flow.
The EV/EBITDA ratio is determined by dividing enterprise value for the most recent quarter by EBITDA for the most recent 12 months.
Shareholder Yield
A stock’s shareholder yield is the sum of its buyback yield and dividend yield and shows what percentage of total cash the company is paying out to shareholders, either in the form of a cash dividend or as expended cash to repurchase its shares in the open market. Thus, if a company is paying a 5% dividend yield and has a buyback yield of 10%, its shareholder yield would be 15%.
A stock’s buyback yield is determined by comparing the average number of shares outstanding for a fiscal period with the average number of shares outstanding for another fiscal period. In this case, the average shares outstanding for the latest fiscal quarter is compared to the average shares outstanding in the same fiscal quarter a year ago. If a stock currently has 90 million average shares outstanding and it had 100 million average shares outstanding one year ago, the buyback yield would be 10%. Note that the buyback ratio can be negative if the number of outstanding shares has increased.
Unlike other valuation measures, shareholder yield is inversely related with value, with higher shareholder yields implying lower valuations.
Shareholder yield is determined by adding the current buyback yield to the current dividend yield.
Price/Book
The price-to-book ratio was a favorite measure of Benjamin Graham and his disciples who sought companies with a share price below their book value per share. While the market does a good job of valuing securities in the long run, in the short term it can overreact to information and push prices away from their true value. Measures such as the price-to-book-value ratio help to identify which stocks may be truly undervalued and neglected.
Fama and French’s “The Cross-Section of Expected Stock Returns,” published in the June 1992 Journal of Finance, is among the most-cited research on the performance of the price-to-book ratio in modern times. In the study, they documented significantly higher returns for portfolios of low price-to-book stocks compared to portfolios of high price-to-book stocks. Data published by Kenneth French on his website shows portfolios constructed of stocks whose price-to-book ratios rank in the bottom third of all stocks beating portfolios of stocks whose high price-to-book ratios rank in the top third by an annualized difference of 9.9% per year between 1927 and 2017.
The price-to-book ratio is calculated by dividing the share price by book value per share. Book value is generally determined by subtracting total liabilities from total assets and then dividing by the number of shares outstanding. It represents the value of the shareholders’ equity based upon historical accounting decisions.
Price/Free Cash Flow
A company’s sales and earnings are useful measures, but for a company to survive, it must have the cash to finance its activities. Companies that generate sufficient cash can expand during periods of economic expansion, as well as cover expenses when sales decline during slowdowns.
Cash flow is reported on the cash flow statement. It is the sum of cash from operations, cash from investing and cash from financing adjusted for exchange rate effects. Free cash flow is calculated by subtracting capital expenditures and dividend payments from cash flow from operations. The price-to-free-cash-flow (P/FCF) ratio is calculated by dividing the share price by free cash flow per share for the most recent 12 months.
The cash flow statement is harder to manipulate through accounting techniques than earnings. Unlike earnings, which are an accounting figure, cash flow represents the net total of cash flowing into and out of the company over a given period.
If you have any questions or comments about this week’s topic, or have anything to say about A+ Investor, reach out to us directly at aplus@aaii.com.
