A better alternative to P/E or P/B?

A new study shows that a lesser-used valuation metric might have value

By John Reese May 21, 2010 6:14PM

The stock investing world is filled with well-known valuation metrics -- the price/earnings ratio, price/book ratio, free cash flow yield, price/sales ratio, and numerous other variables have been used by successful investors to find winning stocks.

 

A new study shows, however, that a much less popular valuation metric -- the gross profits-to-assets ratio -- may be one of the better predictors of future stock performance.

 

The study, entitled “The Other Side of Value: Good Growth and the Gross Profitability Premium”, was performed by Robert Novy-Marx of the University of Chicago and National Bureau of Economic Research. (Thanks to The Stingy Investor and CXO Advisory Group for highlighting the research.) In it, Novy-Marx finds that the gross profits/assets ratio is actually a better predictor of future returns than more widely used earnings- and cash flow-based valuation metrics.

 

"In a horse race between these three measures of productivity, gross profits-to-assets is the clear winner," Novy-Marx writes. "Gross profits-to-assets has roughly the same power predicting the cross-section of expected returns as book-to-market. It completely subsumes the earnings based measure, and has significantly more power than the measure based on free cash flows." In addition, he says the gross profits/assets measure is a predictor of long-term earnings and free cash flow growth.

 

Novy-Marx's research, which covers the period from July 1963 to December 2009 and excludes financial firms, finds that companies in the top fifth of the market based on gross profits/assets returned 0.33% per month more than those in the bottom fifth. "Profitable firms generate significantly higher average returns than unprofitable firms, despite having, on average, lower book-to-markets and higher market capitalizations," Novy-Marx writes.

 

He also finds that a portfolio that is half made up of high gross profit/assets stocks and half made up of high book/market stocks would have generated average monthly excess returns of 0.75%. And he adds, "Controlling for gross profitability explains most earnings related anomalies, as well as a wide range of seemingly unrelated profitable trading strategies."

 

Novy-Marx's research got me thinking about which high gross profit/assets firms also get high marks from my Guru Strategies, each of which is based on the approach of a different investing great. Here are some of the best of the bunch, along with their gross profits/assets ratios and the Guru Strategies that are keen on them.

 

The TJX Companies (TJX): Owner of T.J. Maxx and Marshalls discount stores has a 68% gross profits/assets ratio, and gets strong interest from my Peter Lynch-, Warren Buffett-, and James O'Shaughnessy-based models. 


Eli Lilly & Co. (LLY): Pharmaceutical giant gets approval from both my David Dreman- and Peter Lynch-based approaches, and also boasts a 65% gross profits/assets ratio. 


Johnson & Johnson (JNJ): Warren Buffett's Berkshire Hathaway has a big stake in this diversified healthcare firm, and my Buffett-based model (and my James O'Shaughnessy-based approach) is also high on the stock. The firm has a 46.4% gross profits/assets ratio. 

 

Baxter International, Inc. (BAX): Another healthcare firm, this medical equipment company has a gross profits/assets ratio of 38.1%. It's a favorite of my Peter Lynch-inspired strategy. 


Exxon Mobil Corporation (XOM): Energy giant is one of the largest companies in the world, and has a gross profits/assets ratio of 37.1%. It gets approval from my James O'Shaughnessy-based model. 


Disclosure: I'm long TJX, LLY, JNJ, and XOM. 


John Reese is founder and CEO of Validea.com, a premium investment research site, and Validea Capital Management, a separate account advisory firm. He is author of the new investing book, "The Guru Investor: How to Beat the Market Using History's Best Investment Strategies". 


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