Scientific Beta

Many index providers claim that the book-to-price ratio is no longer a sufficient descriptor of the value factor. They argue that it has become outdated because reported book value ignores investments into intangible assets. As a solution, they propose including other valuation ratios, such as earnings-to-price, sales-to-price, cash flow-to-price or dividend yield. However, this solution overlooks a superior alternative: intangible capital can be estimated and added to the book value. In this paper, we compare these alternative solutions and show that including unrecorded intangibles in the book value increases the value premium and aligns with risk-based explanations. By contrast, other valuation ratios do not add investment value beyond picking up implicit exposure to factors other than value. Such valuation ratios also fail to improve the alignment of value strategies with risk-based explanations.

Many index providers claim that the book-to-price ratio is no longer a sufficient descriptor of the value factor. They argue that it has become outdated because reported book value ignores investments into intangible assets. As a solution, they propose including other valuation ratios, such as earnings-to-price, sales-to-price, cash flow-to-price or dividend yield. However, this solution overlooks a superior alternative: intangible capital can be estimated and added to the book value.

In this paper, we compare these alternative solutions. Beyond a naïve analysis of performance, we ask:

i) whether improvements persist when considering implicit exposure to other factors, and
ii) whether they align with a risk-based explanation for the value factor.

We show that including unrecorded intangibles in the book value increases the value premium and aligns with risk-based explanations. By contrast, other valuation ratios do not add investment value beyond picking up implicit exposure to factors other than value. Such valuation ratios also fail to improve the alignment of value strategies with risk-based explanations.

It is useful to question the traditional definition of the value factor which, as a composite, is problematic. Combining different valuation ratios creates implicit exposure to factors such as profitability. For multi-factor investors, this creates factor overlap and reduces risk-adjusted performance. Composite value definitions no longer add value because of changes in investment practices that have led to a rise of multi-factor investing. On the other hand, the traditional academic definition, book-to-price, has not lost its meaning in the age of intangibles. We can adjust reported book values to account for intangibles. Such an adjustment delivers significant value-added for multi-factor investors.