Slightly Different Measure of Valuation

January 16, 2013
By

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I grow tired of the tried and true standard measures of valuation, and from time to time I try to think of alternate methods.  One thought was to analyze Ken French’s Market(ME) to Book(BE) Breakpoints by percentile.  We can see by year at what level is a stock considered cheap relative to the universe.  As these breakpoints move higher, the market is willing to pay a higher price.  In reverse, as these breakpoints move lower, stocks fetch a lower price or can be considered cheaper.  Since there are 20 fifth percentiles, a horizon plot can provide a good overall look at this measure of valuation.

Here is a horizon plot of absolute ME/BE valuation by fifth percentile since 1926.

From TimelyPortfolio

For a more representative look, let’s plot a horizon chart of the ME-BE / historical mean – 1.

From TimelyPortfolio

For one more non-horizon look, we can use an xyplot.

From TimelyPortfolio

In theory, I think this could provide yet another gauge of the cheapness of stocks, but of course, there is lots of research to be done.

R Code from Gist:

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