Portfolio strategies using EVA, earnings ratio or book‐to‐market

Abstract

Purpose Past studies have shown that investment strategy using two popular metrics, the earnings‐price ratio (EP) and book‐to‐market ratio (BM) enable investors to reap abnormal returns. More recent development of another ratio, economic value‐added‐to‐market value (EVAM) can be seen as a hybrid of EP and BM ratios. The purpose of this study is to examine whether portfolios created by utilizing the EVAM ratio will generate higher returns than portfolios formed with EP or BM ratios. Design/methodology/approach Utilizing the EVA data obtained from Stern Stewart & Co. and financial data from COMPUSTAT and center for research in security prices (CRSP), portfolios are created following the Fama and French portfolio formation methodology. The authors form separate portfolios using EP, BM or EVAM ratios where firms are ranked by a ratio in year t, then split into deciles. Then portfolios are constructed in year t + 1 for each decile and equally weighted portfolio returns are calculated. The cumulative ten‐year returns are compared between portfolios formed with EP, BM and EVAM ratios. Findings There are three interesting findings. One, the EP portfolios depict results that have long been documented. That is, value stock (low price‐to‐earnings ratio firms) and growth stocks (high price‐to‐earnings ratio) exhibit the highest returns. Two, the ten BM portfolio performances are not statistically different. Three, the EVAM ratios indicate that the negative EVAM (lowest decile) portfolio exhibit the highest return and the second highest return is generated by the highest EVAM portfolio. The general results of the thirty portfolios show that the highest EVAM ratio (EVAM10) performs the best. However, the pairwise mean differences between EP, BM and EVAM portfolios do not show statistical differences over the 1995–2004 period. Originality/value Although investment strategies using EP ratio and BM ratio have been thoroughly studied, investment strategy using EVAM ratio has not. Given that it has been documented that EVA is a better conceptual measure of value, portfolio managers or investors would be interested to know whether utilizing EVA for investment strategy would earn a higher return than strategies that use EP or BM ratios.

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