Intrinsic Value: A Solution to the Declining Performance of Value Strategies

The paper proposes to use intrinsic value as an alternative measure of fundamentals in predicting stock returns. To construct intrinsic value, we add the book value of equity to the discounted sum of future economic profits and use a firm-specific discount rate that accounts for size and leverage. The intrinsic-value-to-market (IVM) ratio has strong forecasting power for the cross-section of stock returns even in the last two decades, where the book-to-market ratio and similarly constructed price multiples fail to predict returns. In particular, the CAPM alpha of a long-short portfolio of large stocks based on the IVM ratio is 56 bps per month between 1999 and 2023, while the alpha of the corresponding portfolio based on the book-to-market ratio is indistinguishable from zero. We relate the difference in performance between the two approaches to the fact that book value better approximates the true intrinsic value of the firm only when future economic profits are not a significant component of firm value. In particular, as discount rates decline, the component of firm value due to future economic profits becomes more relevant and the link between book value and intrinsic value becomes more tenuous. These findings have significant implications for investors and financial analysts seeking to refine stock valuation methodologies in response to evolving market conditions and macroeconomic regimes.