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 They argue that it has become outdated because reported book value ignores investments into intangible assets.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 an article published in the July 2020 issue of the Journal of Portfolio Management, Scientific Beta compares these alternative solutions. 

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 They argue that it has become outdated because reported book value ignores investments into intangible assets.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 article, the authors compare these alternative solutions. Beyond a naïve analysis of performance, they ask (1) whether improvements persist when considering implicit exposure to other factors and (2) whether they align with a risk-based explanation for the value factor. The authors 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.