Are Book Values Still Useful in Value Investing?

A company’s book value is basically the net worth of its assets as found on the balance sheet, and it's usually about equal to the amount that all shareholders will receive if the company liquidates and pays off all of its liabilities.

Book value has been one of the most important accounting metrics used by value investors when assessing investments. It has been used by investors for decades. However, with the shift to a knowledge-based economy, it has become less important these days, as pointed out by Reference [1],

In recent decades, however, book values have become a less relevant valuation anchor. One reason is that, with the shift to a knowledge-based economy, public companies’ most valuable “assets” are often related to intellectual property, brand recognition, and customer loyalty, which are typically omitted from firms’ balance sheets.

The authors went on to study the usefulness of the book-to-market ratios and concluded,

We study the use of firms’ book-to-market ratios in value investing and its implications for comovements in firms’ returns and trading activity. We show that B/M has become increasingly detached from common alternative valuation ratios over time while also becoming worse at forecasting returns and growth in absolute and relative terms. Despite these trends, some major U.S. stock indexes and funds continue to rely on B/M when identifying value stocks and forming portfolios. Consistent with this reliance shaping market outcomes, we find firms’ stock returns and trading volumes comove along B/M in excess of comovement in their fundamentals. Taken together, our findings highlight a form of institutional inertia in financial markets, where some key participants shape market outcomes by continuing to rely on signals that previously worked well, despite a steady decline in signal content.

In short, book-to-market ratios are no longer accurate at forecasting returns, and they are  increasingly detached from other valuation ratios.

References

[1] Choi, Ki-Soon and So, Eric C. and Wang, Charles C. Y., Going by the Book: Valuation Ratios and Stock Returns (2021). Available at SSRN: https://ssrn.com/abstract=3854022

Originally Published Here: Are Book Values Still Useful in Value Investing?