"Which Valuation Metrics Work Best for Stock-Picking Within the Sector?"

FIN630 Section 9044
Professor John Halstead
October 30, 2011

Overview
The article entitled “Which Valuation Metrics Work Best for Stock-Picking Within the Sector?” studies the effectiveness of several market valuation multiples in predicting outperformance of regulated utility stocks relative to the industry as well as the S&P 500 index from 1972 to 2010. The study that was conducted utilizes a database of financial information on publicly traded regulated utility stocks. “The initial source for the universe of firms was from FactSet, and consisted of all publicly traded stocks, that were classified as "Electric Utilities" under the Fact Set industry classification scheme.” FactSet is a company that provides computer-based financial data and analysis for financial professionals on global markets, public and private companies. The study started in 1972 with 80 publicly traded regulated utilities and ends in 2010 with 41 active regulated utilities. “This drop in the number of publicly traded regulated utilities over the last 40 years largely reflects the consolidation wave of the late 1990s and early 2000s, as well as the impact of deregulation during this period.” Black Book (2011).

Methodology
At the end of each month during the period of 1972-2010, we ranked the universe of regulated utility stocks were ranked on the basis of the following eight valuation metrics, and then sorted the stocks into quintiles. We tracked the subsequent total returns of the cheapest quintiles on each metric over one-, three-, five- and 10-year investment horizons relative to regulated utilities as a group and the S&P 500. The eight valuation metrics utilized in the study are: Price-To-Earnings: is a valuation ratio of a company's current share price compared to its per-share earnings.
Price-To-Earnings = Market Value per Share Earnings per Share (EPS)

Price-to-forward-earnings: “is a measure of the price-to-earnings ratio (P/E) using forecasted earnings for the P/E calculation. The earnings used are just an estimate and are not as reliable as current earnings data, there is still benefit in estimated P/E analysis. The forecasted earnings used in the formula can either be for the next 12 months or for the next full-year fiscal period.”
(http://www.investopedia.com)

Price-to-Book Value: A ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share.

Price-to-cash flow from operations (CFO): “A measure of the market's expectations of a firm's future financial health. Because this measure deals with cash flow, the effects of depreciation and other non-cash factors are removed. Similar to the price-earnings ratio, this measures provides an indication of relative value.” Martin,J.,&Titman,S.(2011)

P/E-to-long-term growth rate (PEG): A ratio used to determine a stock's value while taking into account earnings growth.

“PEG is a widely used indicator of a stock's potential value. It is favored by many over the price/earnings ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued.” Martin,J.,&Titman,S.(2011).
Dividend Yield: is a financial ratio that shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock.
Dividend Yield
“Dividend yield is a way to measure how much cash flow you are getting for each dollar invested in an equity position - in other words, how much "bang for your buck" you are getting from dividends.” Martin,J.,&Titman,S.(2011)
Enterprise Value-to-EBITDA: “A financial ratio that measures a company's return on investment. The EBITDA/EV ratio may be preferred over other measures of return because it is normalized for differences between companies. Using EBITDA normalizes for differences in capital structure, taxation and fixed asset accounting. Meanwhile, using enterprise value also normalizes for differences in a company’s capital structure. ” Martin,J.,&Titman,S.(2011)
EV-to-EBIT: “A financial ratio used to measure a company's return on investment. While the EBIT/EV ratio is not very commonly used, it does have certain advantages in comparing companies. First, using EBIT as a measure of profitability eliminates the potential distorting effects of differences in tax rates. Secondly, using EBIT/EV normalizes for the effects of different capital structures.” Martin,J.,&Titman,S.(2011)
Research Findings
The research indicates that out of the eight metrics, Price-to-CFO and Price-to-book seem clearly superior to the other valuation multiples. What came as a surprise is that Dividend Yield was the worst predictor of utility stock performance. “Based on the average one-year total returns during 1972-2010, the cheapest quintile of stocks based on price-to-CFO achieved the greatest outperformance (+6.0% versus the S&P 500 and +4.5% versus the sector), followed closely by the cheapest quintile based on price-to-book (+4.8% versus the S&P 500 and +3.3% versus the sector). Price-to-earnings (+4.5% versus the S&P 500 and +3.0% versus the sector), price-to-forward-earnings (+3.9% versus the S&P 500 and +3.1% versus the sector), and EV-to-EBITDA (+3.6% versus the S&P 500 and +2.8% versus the sector) were the next best metrics, trailed closely by EV-to-EBIT (+3.3% versus the S&P 500 and +2.5% versus the sector), with PEG and dividend yield trailing relatively far behind” Black Book (2011)
The research also showed the Price-to-CFO also had the highest consistency of outperformance, “both relative to the S&P 500 (63% of the time) and also relative to the sector (73% of the time). Other valuation multiples were not as uniformly consistent across both the S&P 500 and the sector. Relative to the S&P 500, price-to-earnings showed the highest consistency after price-to-CFO, with the cheapest quintile of utility stocks ranked on this metric outperforming the S&P 500 61% of the time. Relative to the sector, EV-to-EBITDA showed the highest consistency after price-to-CFO, with the cheapest quintile of utility stocks ranked on this metric outperforming the sector 71% of the time.” Black Book (2011)
The least effective metric in predicting outperformance was Dividend Yield with “(+2.2% versus the S&P 500 and +0.6% versus the sector). To underscore the ineffectiveness of dividend yield, we would point out that alone among the eight valuation metrics we considered, the most expensive quintile of stocks based on dividend yield (i.e., the lowest-yielding stocks) outperformed the cheapest quintile portfolio (the highest-yielding stocks). While the highest-yielding quintile outperformed the S&P 500 by +2.2% and the sector by +0.6%, on average, the lowest-yielding quintile portfolio outperformed the same benchmarks by +3.2% and +1.6% respectively, with similar consistency of outperformance.” Black Book (2011) In conclusion, the analysis of the various market valuation metrics versus subsequent total return finds that portfolios comprising the cheapest quintile of regulated utility stocks based on Price-to-CFO, Price-to-Book, Price-to-Earnings, Price-to-Forward Earnings, EV-to-EBITDA and EV-to-EBIT outperforms both the regulated utilities as a group and the S&P 500. The outperformance of these portfolios is greatest over short holding periods; particularly over a one-year period and is reduced as the holding period is extended to three, five and 10 years.

References
"Which Valuation Metrics Work Best for Stock-Picking Within the Sector?. (2011). Black Book-U.S. Utilities: Strategies to Outperform the Market in a Low-Beta Sector, 45-55. Retrieved from EBSCO host.
Price to Earnings. Investopedia. Retrieved 05:49, October 29, 2011, from http://www.investopedia.com/terms/p/price-earningsratio.asp#axzz1c6b2GeiY
Forward Price to Earnings. Investopedia. Retrieved 05:39, October 29, 2011, from http://www.investopedia.com/terms/f/forwardpe.asp#axzz1c6b2GeiY
Book to Price Value. Investopedia. Retrieved 05:39, October 29, 2011, from http://www.investopedia.com/terms/p/price-to-bookratio.asp#axzz1c6b2GeiY
Martin,J.,&Titman,S.(2011). Valuation: The Art and Science of Corporate Investment Decision (2nd ed).Boston, MA: Pearson Education Inc.