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Betting on Ratios

It really doesn't matter what ratio you employ; stocks with lower valuations beat the benchmark in the last five years

Every celebrity investment guru has a favourite ratio or combination of ratios. Even in India, most stock market pundits swear by the price-to-earnings (P/E) ratio. Some others would vouch for the supremacy of the price-to-book-value (P/BV) ratio and the enterprise multiple, among others. Sure, every investor knows that basing one's investment on the basis of a ratio or a combination of ratios is a better way to go rather than ignoring them altogether.

We wanted to see how investments based on various valuation ratios fared in the last five years. We selected four commonly used ratios - P/E, P/BV, enterprise multiple and enterprise value to sale - and applied them to the S&P BSE 500 index. We, then, arranged the individual lists of stocks in an ascending order. We further selected top 10 per cent and bottom 10 per cent of the stocks from the lists. A comparison of the average annual performance of the top 10 per cent of stocks and the bottom 10 per cent of the stocks from February 3, 2010, to February 4, 2015, revealed some interesting facts (see the table).

Comparing by tens
Valuation ratiosReturns (%) Top ten decileBottom ten decile
P/E11.123.3
P/BV12.0413.91
EV/EBIDTA14.545.09
EV/net sales15.85.96
S&P BSE 50011.02

One, barring the case of stocks arranged by P/BV, the top 10 per cent sets of stocks managed to outperform the market. The stocks with low EV/net sales ratio fared the best. They beat the market benchmark by an average of about 4 per cent a year. On the other hand, the low P/E group only outperformed by 0.10 per cent a year. However, irrespective of the ratio employed, stocks selected on the basis of lower valuations did well in the five-year period, when compared with the returns of the benchmark index.

In contrast, stocks with higher valuations hurt returns. For instance, the high EV/EBIDTA group trailed the benchmark by a whopping 6.7 per cent a year.

A note of caution, though. Investors should keep in mind that the performance of each ratio tends to change over a period of time in the market.

Though most of the valuation ratios used may be known to most investors, here is a summary of them to refresh the memory.

Price/earnings (P/E) ratio: The most popular yardstick for assessing a stock's value is the humble price-to-earnings ratio (P/E). It compares a stock's price to its earnings over the last 12 months. Sensible investors prefer to buy lots of earnings power for a low price, everything else being equal.

Price/book value (P/BV) ratio: Next on the popularity scale is the P/BV ratio, which measures how expensive a stock is as compared to its net assets (assets less liabilities). This ratio is loved by academics and value investors.

The other two ratios use two accounting measures that are popular among analysts. The first measure is the enterprise value (EV), which is the market capitalisation of a business plus its debt less cash and cash equivalents. It estimates what a buyer may have to pay for a firm, while settling its debts at the same time.

EV/EBIDTA (enterprise multiple): EBITDA is a rough measure of a firm's operational profitability independent of its capital structure. EBITDA allows you to compare a firm that finances itself with lots of debt but little equity against a company that relies largely upon capital put up by shareholders, with next to no debt in the mix. A low ratio indicates that a company might be undervalued. Keep in mind that enterprise multiples can vary depending on the industry. Therefore, it's important to compare the multiple to other companies or to the industry in general.

EV/sales: This valuation measure compares the enterprise value of a company to the company's sales. It gives investors an idea of how much it costs to buy the company's sales. This measure is an expansion of the price-to-sales valuation ratio, which uses market capitalisation instead of the enterprise value. EV/sales is seen as more accurate because market capitalisation does not take into account the amount of debt a company has. Generally, the lower the EV/sales the more attractive or undervalued the company is believed to be.