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Valuation Beta Research – The End of Price Multiples?

In our Valuation Beta working paper, we emphasized the valuation vs cheapness contrast between intrinsic value and book to price (HML) classifications.  This highlighted that “cheap” HML classifications unsupported by intrinsic value were a source of significant negative alpha, while “undervalued” intrinsic value classifications unsupported by HML were a source of significant positive alpha.

This focus was tethered to the prominent role of the book to price factor in asset pricing literature, as we simply set out to study the contribution of Applied Finance’s intrinsic value estimates in an asset pricing study format popularized in Fama French’s five factor paper.  As we continue to build out our asset pricing study library, we have further included other commonly-cited price multiples to study in this format.

This valuation vs. cheapness theme is consistent across all price multiples studied, including earnings to price, sales to price, a composite of B/P, E/P, and S/P, iHML (which capitalizes intangible investment directly to book equity), cash flow to price, and EBITDA to enterprise value.  In other words, all price multiples suffer as inadequate proxies to intrinsic value. It is beneficial for investors to understand the wealth compounding that occurs from profitable organic reinvestment over long horizons, which price multiples are ill-equipped to capture.  In addition to this, we observe insignificant alpha characteristics for all price multiples when regressed against the Applied Finance 5 Factor model that incorporates Excess Intrinsic Value, Financing Yield, size, leverage, and the overall market return.

6 Portfolios formed on Size and various price multiples and Size and Applied Finance Intrinsic Value Factor.
Point-in-time factor construction with monthly rebalancing from October 1998 to June 2020.  Cap-weighted returns.

Annualized alpha of 2×3 factors constructed with point-in-time data and monthly rebalancing regressed against candidate asset pricing models. Cap-weighted returns, October 1998 to June 2020.  (Gray = Insignificant return at p-Value 0f 0.05; t-stat in axis label)

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Authors

  • John Holt, CFA joined Applied Finance in 2014 and is involved in the management of both quantitative strategies and analyst driven strategies.

  • Derek Bergen, CFA – Applied Finance Partner  Joined Applied Finance, 2005. Portfolio Manager and Quantitative Research Analyst. B.S. University of Wisconsin-Madison.

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