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As it turned out, P/B was the worst performer of the value measures during the ensuing 14-year rout. The magnitude of the reversal was truly shocking. From 1967 to 2006, the cheapest 30% of U.S. stocks sorted by P/B and weighted by market value outpaced the most expensive 30% by 5.1 percentage points a year, including dividends, according to numbers compiled by financial economist Lu Zhang and his colleagues. But from 2007 to 2020, the cheapest 30% of stocks lagged the most expensive ones by 6.6 percentage points a year.

The wave of technology-enabled companies that began in the 1990s and has since accelerated means businesses increasingly rely on software and systems they develop internally through research and development. The problem is that accounting rules don’t allow them to report internally generated assets on their books, no matter how valuable they might be. The omission understates the companies’ book value and therefore overstates their P/B ratio, causing them to appear more expensive than they truly are.

Adherents of P/B can hedge their bets by adjusting companies’ book value to reflect all assets, not just those recognized by accounting rules. But that would be arduous and time-consuming, assuming systems, processes and other intangibles can even be valued reliably. Zhang and his colleagues have a simpler solution: Swap book value for operating cash flow. The latter, Zhang says, “is a reasonably good estimate of what P/B would look like if internally developed IP were reflected in book value because operating cash flow captures the value of all assets companies use in their core business, whether or not reflected on their books.”
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