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". 



Copyright © 2014 Microsoft. All rights reserved.

Fundamental company data and historical chart data provided by Morningstar Inc. Real-time index quotes and delayed quotes supplied by Morningstar Inc. Quotes delayed by up to 15 minutes, except where indicated otherwise. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by Morningstar Inc.


StockScouter rates stocks from 1 to 10, with 10 being the best, using a system of advanced mathematics to determine a stock's expected risk and return. Ratings are displayed on a bell curve, meaning there will be fewer ratings of 1 and 10 and far more of 4 through 7.

123 rated 1
262 rated 2
480 rated 3
651 rated 4
649 rated 5
629 rated 6
616 rated 7
496 rated 8
346 rated 9
111 rated 10

Top Picks

TAT&T Inc9



Top Stocks provides analysis about the most noteworthy stocks in the market each day, combining some of the best content from around the MSN Money site and the rest of the Web.

Contributors include professional investors and journalists affiliated with MSN Money.

Follow us on Twitter @topstocksmsn.