Value Investing – The Most Important Thing

Companies and indices mentioned:

In a recent analysis, we asked, does the data support growth investing? In this feature, we look at value investing.

The S&P US Value Index is designed to identify ‘cheap’ companies. Let’s see if the three measures it uses can be expected to achieve that.

1. Price-to-book

In our June Quarterly, we discussed the deficiencies of equity, or book value per share, as a measure with any economic meaning. To summarise, shareholders’ equity, or book value, is an accounting residual, meaning it is the balancing item after assets and liabilities have been added up.

A write-off of goodwill, for instance, will result in an equal reduction to book value and artificially increase the price-to-book ratio. Likewise, an increase in the discount rate used to calculate future pension obligations will result in an increase in book value. Book value per share is easily distorted and has no relationship to the value of a business.

2. Price-to-earnings one year forward

The ratio of price-to-forecast earnings seems a sensible way of separating cheap from expensive companies. However, it is deficient. Firstly, analysts in general cannot accurately forecast earnings, even one year hence. Further, analysts are systematically grossly optimistic – forecast growth is, on average, 50% higher than actual growth. So, a valuation ratio with forecast earnings in the denominator is flawed.

Furthermore, the value of a business is a function of the cash it generates that is available to owners, not its accounting earnings. The difference between the two can be sizeable. Price-to-accounting earnings is a far less useful measure of value than price-to-normalised free cash available to shareholders.

3. Enterprise value-to-cashflow from operations

If it’s cash that matters, then perhaps this ratio will do the job. Enterprise value, or the sum of market capitalisation and net debt, relative to cashflow from operations is conceptually appealing. However, when applied mechanically using data drawn directly from financial statements it has considerable limitations. The reason for this is the denominator.

Cashflow from operating activities (CFO) is defined as:

CFO = Net income + non-cash expenses + changes in working capital

  • Non-cash expenses – cash from operations adds back depreciation, but does not subtract capital expenditure. It adds back stock-option compensation, but does not deduct the cash the company must spend to offset the dilutions to existing shareholders from the options granted. Both adjustments are a bit like only counting the goals your team has scored.
  • Working capital – the increases or decreases in inventory and the timing of payments of accounts payable and receivable can produce large swings in the cashflow statement independent of the underlying earnings performance of a business.

Thus ‘cashflow from operations’ produces a number that contains non sensical add-backs, can vary wildly year to year, and deviate significantly from a business’s economic reality, severely limiting its usefulness as a valuation tool.


All three of these ‘Value’ measures capture whether a stock trades on a high or low multiple relative to the market average. What these measures do not capture is where a stock trades relative to where it should trade; in other words, relative to its inherent worth.

Designating stocks on below-average multiples as cheap, or ‘value’, and above-average multiples as expensive makes an implicit assumption that all stocks should trade on the same multiple. Knowing the price of one house relative to the price of another house tells you nothing – they might be of different size, different condition, perhaps even in different cities or countries. Knowing size, condition, location and so on, one can start to form a view of what they are worth.

The most ‘expensive’ house may, in fact, be the cheapest, relative to its value. A low multiple does not mean a cheap stock.

Recapping Value & Growth – The Most Important Thing

‘Growth’ and ‘value’ are terms used with abandon, but they are terms without real meaning. ‘Growth’ implies an ability to identify businesses growing EPS faster than an average that does not exist, either objectively or subjectively.

‘Value’ implies that simple accounting ratios can mechanically rank-order stocks from cheap to expensive relative to their inherent worth. They cannot. To underscore the absence of real meaning and distinction in the terms ‘growth’ and ‘value’, as popularly applied, the S&P US Growth Index and the S&P US Value Index share the same largest holding – Apple.

We don’t believe in the artificial distinction of growth or value. What we do believe in is growth in value. Growth in value occurs through companies earning superior returns on invested capital.

We look to own those select businesses that become more valuable over time, where we can own them at less than today’s value and where we judge the risk of disappointment to be low.

This article was written by Stephen Arnold, CFA, founder and Chief Investment Officer of Aoris Investment Management. Click here to download Stephen’s free Owner’s Manual.


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Stephen Arnold, CFA

Stephen Arnold, CFA

Stephen has been investing in offshore markets for 25 years, making him one of Australia’s most experienced international investors. Before founding Aoris Investment Management in 2017 Stephen was Head of International Equities at Evans & Partners where he directly managed $1bn of client assets. Stephen loves early-morning cycling and lunch-time running around Sydney’s harbour foreshore.