How to measure value these days

There are lots of challenges investors face in the current crisis, but one gets in my view too little attention: how to identify cheap stocks.

I think we can all agree that at the height of the March sell-off practically all stocks were cheap. But since then, markets have recovered, and the question is which stocks are still cheap and which ones are not?

Most often, investors try to identify cheap and expensive stocks by using valuation ratios like the price/earnings-ratio, EV/EBITDA, or price/book-ratio. Let’s sidestep the discussion if these ratios are true measures of value or not for the moment and focus on a big challenge that investors face when using these ratios.

When it comes to PE-ratios, past earnings are in many instances no longer representative of the current circumstances. Thus, trailing PE-ratios lose their information content because the E is too high, and trailing PE-ratios are artificially low. On the other hand, forward earnings may be more accurate but that assumes that analysts are good at forecasting the next 12 months. And in the current environment, this is extremely hard and nigh impossible because nobody knows how the pandemic will unfold and how consumers and businesses will adjust to a “new normal”. Thus, forward PE-ratios have little to no information content because the E is so uncertain that it could be almost anywhere.

The same logic holds if you use EV/EBITDA or similar metrics that rely on some form of corporate earnings.

This is why for the time being, I have reverted to using PB-ratios. I know there are systematic issues with book value (see, for example, here) but in the current environment, book values have an important advantage over any kind of earnings or profit metric: they are intrinsically more stable.

The chart below shows the analyst consensus for earnings growth and book value growth over the next 12 months for a couple of diversified indices. The estimated change in earnings per share (EPS) or EBITDA is typically more than twice as large as the estimated change in book value per share (BPS). It is typically much harder to get a forecast right for a more volatile indicator than for a more stable one. That is just the nature of forecasting. But if analysts are too pessimistic about future earnings growth (which is entirely possible) then forward PE-ratios are too high (because the E is too low) at the moment and stock markets look too expensive based on forward PE-ratios. Similarly, if analysts are too optimistic about future earnings (which they typically are), then forward PE-ratios look too cheap.

Expected earnings and book value growth for indices

Source: Bloomberg.

Thanks to the lower volatility of book value, using the PB-ratio as a valuation metric is much more dependable in this market than the other metrics. This becomes extremely clear if we look at individual companies instead of entire indices. Particularly in the hard-hit sectors and industries, it is anyone’s guess how earnings will look like. Just look at the expected earnings growth and EBITDA growth for Exxon, McDonald’s, and General Motors below. How much uncertainty is there around the expected 90% to 140% decline in earnings (NB: Earnings can swing to losses in which case the decline is more than 100%) compared to the expected 0.5% to 3% change in book value? And thus, how accurate do you think are PE-ratios for these companies vs. PB-ratios?

Expected earnings and book value growth for companies

Source: Bloomberg.