Price Ratios: A Horse Race

Value strategies yield higher returns because these strategies exploit suboptimal behavior of the typical investor and not because these strategies are fundamentally riskier.

—Josef Lakonishok, Andrei Shleifer, and Robert Vishny, “Contrarian Investment, Extrapolation, and Risk”1

The empirical evidence is unqualified: value stocks have beaten both glamour stocks and the market over the long term. This raises two obvious questions: (1) why would anyone buy glamour stocks, and (2) which measure of value has generated the best returns? The answer to the first question is behavioral. Expensive stocks are called “glamour” or “story” stocks for a reason. Glamour stocks seduce investors who ignore base rates and focus instead on the stock's “story.” This can lead investors to extrapolate high historical earnings growth too far into the future, assume an upward trend in stock prices, overreact to good news, or simply conflate an exciting investment opportunity with an exciting technology or idea, irrespective of price. Investors can exploit these irrational behaviors by buying cheap or “value” stocks, but which price ratio should an investor use to assess cheapness? We explore in detail the answer to that question in this chapter.

Practitioners have relied on a variety of price ratios, including the price-to-earnings ratio, the price-to-cash flow ratio, and the enterprise multiple (total enterprise value to earnings before interest and taxes and depreciation ...

Get Quantitative Value, + Web Site: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors now with the O’Reilly learning platform.

O’Reilly members experience live online training, plus books, videos, and digital content from nearly 200 publishers.