Many investors view the current macro backdrop of higher interest rates and tighter monetary conditions as one that’s more conducive to value investing, in terms of investment styles. After all, today’s higher-inflation, higher-interest rate environment makes access to capital more difficult and costly, which can be troublesome to companies relying on debt to fuel operations or growth.

But not all value-oriented funds are built the same. In fact, we believe that many traditional value funds rely too heavily on imperfect metrics for screening stocks  and building portfolios. This is especially true for passive funds that track a traditional value index and, by extension, have portfolios overweight in sectors that  might not be primed to excel in the current environment. We think there’s a better way to build a value-oriented equity index—one that uses a metric that offers a more comprehensive view of a company’s financial health and prospects.

Limitations of traditional “value”

Perhaps the most rudimentary of the traditional value metrics is a stock’s price-to-earnings ratio (P/E), which is derived by dividing its share price by its earnings per share. High P/E is expensive; low is cheap. This is easy to understand, which we love, but it also offers a fairly narrow view in determining a stock’s future prospects. After all, a low P/E viewed in a vacuum cannot reveal the “why.”

One of the key challenges with P/E ratios is that earnings are based on accounting assumptions to some degree. The earnings that a company announces each quarter reflect items like depreciation and projected future costs, and if those assumptions are incorrect (or too aggressive), future earnings could be over-estimated. There also may be a tendency for company management to overspend in things that don’t impact stated earnings, but those costs undoubtedly will be reflected in cash flow measures. All this simply illustrates the potential limitations of any traditional value-oriented methodology that relies too heavily on P/E as its key metric.

Another favored value measure is price-to-book (P/B), which is calculated by dividing a company’s share price by its book value on a per-share basis (or dividing the market capitalization by the company's total book value). Typically, book value is determined by the value of all company assets minus liabilities minus something called intangible assets. Intangible assets—things like the value of brand, patents or other intellectual property—can be quite nebulous. The sometimes-arbitrary values assigned to intangible assets can materially change a P/B calculation. Although P/B can be a valuable input for selecting stocks, it leaves too much open to interpretation, especially when it comes to evaluating certain service-oriented business, among others. In our view, P/B suffers an incomplete view in determining a company’s prospects.

For example, consider how one might view a manufacturing company based on P/B. In order to determine this company’s book value, you need to be able to understand its assets, which in this case are likely based on physical, tangible things that you can touch and feel—such as the land where the facility is located, the actual building structure, the equipment, and all the materials that go into producing the product. Those tangible assets are easy to quantify and therefore make it easier to assess its book value.

But it’s rarely so straightforward today. For many modern companies, a great deal of their value belongs in their intangible assets—their intellectual property that’s harder to quantify. There’s no simple price per-square-foot basis that can be used to definitively value a brand or some proprietary research, even though those things may be critical to a company’s success. This illustrates a key limitation of traditional value strategies that rely on P/B.

Building a better value index?

We believe that forward-looking free cash flow (FCF) is a better metric of business health, and thus a better way from which to build a value-oriented index. Simply stated, FCF is the amount of cash a company is generating after paying all expenses incurred to fund operations and remain in business. In other words, FCF offers insight into a company’s ability to generate excess cash to grow the business or fund other shareholder-friendly activities (stock buybacks, dividends, repaying debt etc.).

Importantly, it’s not just about the recent (i.e. past) free cash flow that a company has generated. We think that it’s imperative to capture a realistic forward-looking assessment of a company, as opposed to relying on historical data. Thus, using a measure of future FCF based on consensus analyst estimates may be a more optimal measure of business health and, by extension, a better predictor of future stock performance.

We believe that FCF is a better starting point to identify companies with solid balance sheets and poised for future success given their favorable financial positions. This looks to be especially important in today’s tighter monetary environment where access to capital will be a priority. Using an equity index that screens for stocks in this manner should be a preferrable way to building a value-oriented portfolio, in our opinion.