A better way to evaluate investments — Eric So

MIT Sloan Asst. Prof. Eric So

In the wake of the economic crisis, many companies these days seem to be undervalued. The current earnings-to-price ratios are high and often market commentators argue that these ratios reflect good opportunities to invest. However, the emergence of undervalued stocks comes at a time of high market uncertainty so it’s more important than ever for investors to identify strong investment opportunities based on a company’s fundamentals.

Building on a concept pioneered by Prof. Joseph Piotroski at Stanford University, Piotroski and I recently developed a new application called the FSCORE (Fundamental Strength Score) that helps investors identify these strong investment opportunities based on a company’s fundamentals. When used to buy “value stocks” with strong fundamentals and sell “glamour stocks” with weak fundamentals, the average return over one year was 23% above the S&P and 37.6% above the S&P over two years.

This is different from the primary way most investors measure a company’s value, which involves using its book-to-market ratio.  Companies with high ratios are considered “glamour stocks” and those with low ratios are “value stocks.” It’s been thought that value stocks tend to earn higher future returns than glamour stocks because they are riskier, but our research shows that it is often expectation errors that lead to mispricing.

We provide insight into whether a firm is likely undervalued or overvalued when we apply our FSCORE analysis. Using this application, we found that glamour stocks with strong expectations and low FSCOREs tend to be overvalued and value stocks with weak expectations and high FSCOREs tend to be undervalued. Among firms whose price is consistent with their fundamental strength, there is no difference in future returns among value and glamour stocks, suggesting that risk is unlikely to be the reason why value stocks have traditionally outperformed glamour stocks.

The FSCORE uses nine signals that are available from public firms’ annual financial statements to measure overall improvement or deterioration of their financial condition. The nine signals include factors, such as: whether the firm is generating positive net income, whether there is growth in the firm’s income, whether the firm is deferring income to the future, whether the firm has enough assets to pay off its liabilities, whether the firm needs to obtain outside funding, and how quickly the firm can turn assets into revenues. Each signal is assigned a value, which is added up to determine the FSCORE. A value of nine indicates very strong fundamentals while a value of zero indicates poor or deteriorating fundamentals.

The FSCORE contributes to the long-standing tradition in investment research of using fundamental analysis by providing a simple metric to identify firm value that is not yet reflected in prices. In addition, the results strongly suggest that the difference between the returns to value and glamour stocks lies in mispricing rather than risk.

Prof. Eric So is the coauthor of “Identifying Expectation Errors in Value/Glamour Strategies: A Fundamental Analysis Approach” with Prof. Joseph Piotroski of Stanford University

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