Introduction
Formulaic value investing is a systematic approach to identifying undervalued stocks based on pre-defined financial formulas and metrics. Unlike traditional value investing, which often involves subjective judgment, formulaic value investing relies on quantitative screens to find mispriced opportunities. In this article, I will discuss the key principles, advantages, and limitations of formulaic value investing, along with practical examples and mathematical models.
What is Formulaic Value Investing?
Formulaic value investing applies strict, rules-based criteria to identify undervalued stocks. It removes emotional biases and ensures consistency in decision-making.
Key Principles of Formulaic Value Investing
- Pre-defined screening criteria – Stocks are selected based on fundamental ratios such as Price-to-Earnings (P/E), Price-to-Book (P/B), and Dividend Yield.
- Margin of safety – The intrinsic value of a stock must be significantly higher than its market price.
- Systematic approach – Stocks are ranked based on objective financial data.
- Long-term orientation – Formulaic value investors hold positions for years to allow mispricings to correct.
Key Metrics and Their Formulas
Price-to-Earnings Ratio (P/E)
The Price-to-Earnings (P/E) ratio is one of the most widely used valuation metrics. It measures how much investors are willing to pay for each dollar of earnings.
P/E = \frac{Market \ Price \ per \ Share}{Earnings \ per \ Share}A low P/E ratio suggests that a stock is undervalued relative to its earnings potential.
Price-to-Book Ratio (P/B)
The Price-to-Book (P/B) ratio compares a company’s market price to its book value.
P/B = \frac{Market \ Price \ per \ Share}{Book \ Value \ per \ Share}A P/B ratio below 1 may indicate that a stock is trading for less than its net assets.
Earnings Yield
Earnings yield is the inverse of the P/E ratio and is useful for comparing stock returns to bond yields.
Earnings \ Yield = \frac{Earnings \ per \ Share}{Market \ Price \ per \ Share}A higher earnings yield suggests better value.
Dividend Yield
The dividend yield measures how much a company returns to shareholders in dividends relative to its stock price.
Dividend \ Yield = \frac{Annual \ Dividends \ per \ Share}{Market \ Price \ per \ Share}A high dividend yield can indicate both an attractive income-generating investment and a potential undervaluation.
How Formulaic Value Investing Works
Step 1: Define the Investment Criteria
A formulaic value investor selects metrics based on historical performance. Common filters include:
- P/E ratio < 15
- P/B ratio < 1.5
- Earnings yield > 6%
- Dividend yield > 3%
Step 2: Screen for Stocks
Investors use financial databases or tools like Bloomberg, Morningstar, or Yahoo Finance to find stocks meeting their predefined criteria.
Step 3: Rank and Select Investments
Stocks that pass the screen are ranked based on their valuation metrics. The cheapest and most fundamentally strong stocks are selected.
Step 4: Portfolio Construction and Rebalancing
A diversified portfolio is built from the highest-ranked stocks. Regular rebalancing (e.g., annually) ensures that only undervalued stocks remain in the portfolio.
Example of Formulaic Value Investing in Action
Let’s assume I want to invest in undervalued stocks using a simplified formulaic value approach. I set the following rules:
- P/E < 15
- P/B < 1.5
- Dividend Yield > 3%
I screen three stocks:
| Company | P/E Ratio | P/B Ratio | Dividend Yield |
|---|---|---|---|
| Stock A | 12 | 1.2 | 4.0% |
| Stock B | 18 | 2.0 | 2.5% |
| Stock C | 14 | 1.4 | 3.2% |
Based on my criteria, Stock A and Stock C qualify for investment.
Advantages of Formulaic Value Investing
- Eliminates Emotional Bias – By following strict rules, investors avoid making impulsive decisions.
- Repeatable Process – Formulaic value investing can be applied consistently over time.
- Proven Long-Term Performance – Studies show that value investing strategies tend to outperform over long periods.
- Risk Management – Using a margin of safety reduces downside risk.
Limitations and Risks
- Value Traps – Some stocks remain cheap for valid reasons, such as declining business fundamentals.
- Underperformance in Growth Markets – During bull markets, value stocks may underperform high-growth stocks.
- Data Dependence – The success of the strategy relies on accurate financial data.
- Market Timing Challenges – Value stocks can remain undervalued for long periods before appreciation.
Historical Performance of Formulaic Value Investing
Academic research supports the effectiveness of value investing. For example:
- Fama and French’s (1992) Three-Factor Model found that stocks with low P/B ratios tend to outperform the broader market.
- Studies show that over the past 50 years, a portfolio of low P/E and low P/B stocks has delivered superior risk-adjusted returns compared to growth stocks.
Below is a comparison of historical returns:
| Investment Strategy | Average Annual Return |
|---|---|
| Formulaic Value Investing | 12.5% |
| Growth Investing | 9.0% |
| S&P 500 (Market Average) | 10.2% |
Formulaic value investing has historically outperformed broad market indices, making it a compelling strategy for long-term investors.
Conclusion
Formulaic value investing provides a disciplined, data-driven approach to stock selection. By applying strict valuation metrics, it helps investors avoid common psychological pitfalls and identify undervalued opportunities. While the strategy has risks, its long-term historical performance suggests that it can be an effective method for achieving superior returns.
