Improved alternatives to price multiple and earnings growth ratios used by bottom-up investors

Abstract

To reduce large files of data into manageable subsets of stocks marked for further review, bottom-up investors utilize spreadsheet software to sort key financial ratios calculated for all equities contained within. Flaws associated with the commonly used price-to-earnings (PE), price-to-book (PB) and expected earnings growth (EG) ratios result in stocks incorrectly included in and excluded from the filtered subsamples. To eliminate these problems, two newly created and two existing ratios are proposed. Of these, the earnings growth yield (EGY) ratio provides the greatest improvement relative to its mainstream competitor. Specifically, EGY is superior to EG in proportionality, numerical interpretation and accuracy of bottom-up stock rankings. Value Line Investment Survey stock screener data is examined to exemplify the magnitude of EG’s interpretation and ranking irregularities, both of which are avoided by the EGY ratio.

Keywords:

• stock investing
• bottom-up approach
• price-to-earnings
• price-to-book
• earnings yield
• book-to-price
• expected earnings growth
• earnings growth yield
• tangible book-to-price ratio

JEL Classification:

• G10
• G11