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November 27, 2013 | Research Brief

The Value Trap

Assess the risk associated with the growth of a so-called value stock by considering both its book-to-price and earnings-to-price ratios.


The Idea

Assess the risk associated with the growth of a so-called value stock by considering both its book-to-price and earnings-to-price ratios.

The Research

Typically, the term value is used to describe a company with a low price-to-book ratio (or P/B), the comparison of a firm’s stock price to the book value of its equity, while growth is applied to a company with a high P/B. Investors buy a value stock — in theory a stock mispriced by the market — expecting to see greater returns.

Indeed, says Professor Stephen Penman, over the last 50 years so-called value stocks have outperformed growth stocks on average. But, in a recent paper with Francesco Reggiani of Bocconi University, Penman argues that the terms value and growth are confounding. They don’t actually tell investors much about the companies they’re being used to describe. Value can mean growth, but with risk attached. For investors, this is called a value trap — a firm that appears mispriced but is actually priced low because risk accompanies its potential earnings prospects. Looking at just P/B, though, it’s impossible for investors to tell the difference. Penman and Reggiani’s analysis shows that investors need to consider the earnings-to-price ratio (or E/P) as well.

Practical Applications

Investors
You can use this research to refine the way you evaluate investments to elucidate the risk associated with so-called value stocks.

To help clarify the source of this risk, the researchers point to an accounting method that firms commonly employ called conservative accounting. Under this accounting, customers’ orders aren’t booked until the revenue is in hand. Even investments in the future, such as product development, advertising, and new store openings, may be expensed in the short term and not booked as assets. If a new product is still under development or a new drug awaits FDA approval, a firm’s expectation of payoff is that much riskier. That’s very different from buying an inventory that is ready to sell. As a result, accountants defer potential earnings from these assets to the future. They are indicating that the implied earnings growth from the investments is risky.

Penman and Reggiani explored the effects of this technique by looking at 50 years of financial data from Compustat. They analyzed the earnings-to-price ratio (E/P) and book-to-price ratio (B/P) of each firm listed, as well as its annual returns over the following year. They show that, for a given E/P, B/P indicates the amount of risk attached to the firm’s potential earnings growth. From that, they found the need to enhance the famed Fama and French model (an asset pricing model that targets three factors — the market, size, and whether or not a firm is a value stock). Penman and Reggiani assert that E/P and B/P should be used in concert, rather than just the latter.

Stephen Penman is the George O. May Professor of Accounting at Columbia Business School.

Read the Research

Stephen Penman, Francesco Reggiani

"Returns to Buying Earnings and Book Value: Accounting for Growth and Risk"

View abstract/citation  View Research  


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