Investors may rely too heavily on a financial measure that no longer reflects the economic fundamentals of modern business. What should investors do? Research by Charles C.Y. Wang and colleagues
Investors may be relying too heavily on a formerly tried-and-true tool that isn’t paying off as well today. That means investors may need to do more homework if they want to pinpoint valuable stocks in the future
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What if a bedrock method that investors have relied on for decades to find cheap-but-promising stocks to buy low and sell high no longer works well?
The book-to-market ratio has been used since at least the Great Depression to identify undervalued stocks. But it has become so detached from a modern economy driven by research and intellectual property that it no longer accurately signals so-called value stocks, suggests new research from Charles C.Y. Wang, Harvard Business School’s Glenn and Mary Jane Creamer Associate Professor of Business Administration.
Investors use book-to-market ratios to spot potentially underpriced stocks, and major stock indexes and institutional investors lean on the metric as well. Yet, in an examination of thousands of stocks over a period of nearly 40 years, Wang and colleagues find that the book-to-market ratio’s correlation with other valuation ratios fell from 75 percent to 45 percent. The metric is no longer accurately predicting future returns and growth while the other valuation metrics continue to do so.
This article was provided with permission from Harvard Business School Working Knowledge.