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Lessons for Investors

If low price-to-book-value ratio stocks are riskier than average or have lower returns on equity, a more discerning strategy would require you to find mismatches—stocks with low price-to-book ratios, low risk and high returns on equity. If you used debt ratios as a proxy for default risk and the accounting return on equity in the last year as the proxy for the returns that will be earned on equity in the future, you would expect companies with low price-to-book value ratios, low default risk and high return on equity to be undervalued.

This proposition was partially tested as follows: All NYSE stocks from 1981 to 1990 were screened according to both price-book-value ratios and returns on equity at the end of each year. Two portfolios were created: an undervalued portfolio that each year had low price-book-value ratios (in bottom quartile of all stocks) and high returns on equity (in top quartile of all stocks); and an overvalued portfolio that each year had high price-book-value ratios (in top quartile of all stocks) and low returns on equity (in bottom quartile of all stocks). Returns on each portfolio were then estimated for the following year. Table 4.9 summarizes returns on these two portfolios for each year from 1982 to 1991.


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