"Cheap" classic value companies versus Quality (growing intrinsic value) companies

Classic value metrics such as P/B, P/E or DY do not represent intrinsic value. 

To illustrate this, Grantham says when he poses the following question to investment audiences

• “I give you Coca Cola at 1.2x book or General Motors 1.0x. 
• Which would you have?” he gets no takers for GM. 

That is the clearest difference between P/B as a corner stone of classic value, and not intrinsic value.

The extra qualities represented by Coca Cola are worth a premium. The only question is, “how much?’ 


OUTPERFORMANCE OF INTRINSIC VALUE (QUALITY) VS. OF LOW P/B.

What this means is that

• any outperformance of intrinsic value (quality) is pure alpha, 
• where outperformance of low P/B (as it is for many small caps) is compensation for a high risk premium. 

To support this point, Grantham points out that had the US government not bailed out the behemoths of the US financial system in the crises of 2008, many companies trading at low price to book ratios would have gone bankrupt (not just in the US, but across the world due to the interconnectedness of the global financial system).

What we learn from Buffett’s review of the first 25 years of his investment experience is that this risk premium sometimes comes back to bite you. 

It should not be surprising that in times of deep economic crises, more of these “cheap,” classic value companies go bust than is the case for the “expensive” intrinsic value companies.

Further studies found that classic value investment opportunities tend to coincide with other characteristics such as

• small capitalization, 
• illiquidity, 
• high leverage, or 
• dissipating fundamentals due to severe cyclical conditions.  

 “The pure administration of classic value investment style really needs a long term lock-up, like Warren Buffet (Partnership) has or it will have occasional quite dreadful client problems.” 

Investment history is replete with examples of such dreadful client problems – Gary Brinson of UBS in the late 90s, Tony Dye who ran a value based contrarian portfolio for Phillips and Drew, and low PE value manager David Dreman in 2008, all lost the majority of their clients due to severe underperformance. 

The big lesson to learn here is not that classic value investing doesn’t work. 

It is the fact that it works far less frequently in recent times than it used to, enough to produce dreadful client problems.  

Multiples based on Comparables

This method compares relative values estimated using multiples to determine whether an asset is 

• undervalued, 
• overvalued or 
• fairly valued.  

The benchmark multiple can be any of:

• A multiple of a closely matched individual stock.
• The average or median multiple of a peer group or the firm's industry.
• The average multiple derived from trend or time-series analysis.

Analyst should be careful to select only those companies that have similar size, product lines, and growth prospects to the company being valued as comparables.

Price to cash flow ratio 

P/CF = Market price of share / Cash flow per share

Price to sales ratio

P/S = Market price per share / Net sales per share

P/S = Market value of equity / Total net sales

Price to Book Value ratio

P/BV = Current market price of share / Book value per share

P/BV = Market vale of common shareholders' equity / Book value of common shareholders' equity

where:

Book value of common shareholders' equity 

= (Total assets - Total liabilities) - Preferred stock

Price Multiples - Relative Valuation

Price multiples are ratios that compare the price of a stock to some sort of value.

Price multiples allow an analyst to evaluate the relative worth of a company's stock.

Popular multiples used in relative valuation include:

• price-to-earnings,
• price-to-sales,
• price-to-book, and
• price-to-cash flow.

Primary aim of management is to increase the book value and the market value of the company.

The primary aim of management is to increase

• the book value and 
• market value of the company.

Book Value

Book value (shareholders' equity on the company's balance sheet) is calculated as total assets less total liabilities.

It reflects the historical operating and financing decisions made by the company.

Management can directly influence book value (e.g., by retaining net income).


Market Value

However, management can only indirectly influence a company's market value.

Market value of a company is primarily determined by investors' expectations about the about, timing and uncertainty of the company's future cash flows

A company may increase its book value by retaining net income, but it will only have a positive effect on the company's market value if investors expect the company to invest its retained earnings in profitable growth opportunities.

If investors believe that the company has a significant number of cash flow generating investment opportunities coming through, the market value of the company's equity will exceed its book value.



Price to book ratio (market to book ratio)

A useful ratio to evaluate investor's expectations about a company is the price to book ratio.

If a company has a price to book ratio that is greater than industry average, it suggests that investors believe that the company has more significant future growth opportunities than its industry peers.

It may not be appropriate to compare price to book ratios of companies in different industries because the ratio also reflects investors' growth outlook for the industry itself.


Accounting Return on Equity

An important measure used by investors to evaluate the effectiveness of management in increasing the company's book value is accounting return on equity.

Valuing companies with little or no earnings or with very volatile and highly unpredictable earnings.

Companies with no earnings or very volatile and highly unpredictable earnings

Some companies, like high tech startups, have little, if any, earnings.

If they do have earnings, they tend to be quite volatile and therefore highly unpredictable.

In these cases, valuation procedures based on earnings (and even cash flows) are not much  help.





Price to Sales ratio or Price to Book Value ratio

Investors turn to other procedures - those based on sales or book value.

While companies may not have much in the way of profits, they almost always have sales and, ideally, some book value.

Price to Book Value Ratio

Price to Book Ratio

P/BV ratio
= Market price of common stock / Book Value per share

Unless the market becomes grossly overvalued (1999 and 2000), most stocks are likely to trade at multiples of less than 3 to 5 times their book value.

There is usually little justification for abnormally high price to book value ratios - except perhaps for firms that have abnormally low levels of equity in their capital structures.

Other than that, high P/BV multiples are almost always caused by "excess exuberance."

As a rule, when stocks start trading at 7 or 8 times their book values, or more, they are becoming overvalued.




Investor Mistakes (Short-lived Growth)

So called value stocks are stocks that have low price to book ratios, and growth stocks are stocks that have relatively high price to book ratios.

Many studies demonstrate that value stocks outperform growth stocks, perhaps because investors overestimate the odds that a firm that has grown rapidly in the past will continue to do so (Short-lived Growth).

The Five Rules for Successful Stock Investing 10

Valuation – The Basics

Even the most wonderful business is a poor investment if purchased for too high a price. To invest successfully means you need to buy great companies at attractive prices.

Investors purchase an asset for less than their estimate of its value and receive a return more or less in line with the financial performance of that asset. Speculators, by contrast, purchase an asset not because they believe it's actually worth more, but because they think another investor will pay more for it at some point. The return that investors receive on assets depends largely on the accuracy of their analysis, whereas a speculator's return depends on the gullibility of others.

Over time, the stock market's returns come from two key components: investment return and speculative return. [...] the investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas the speculative return comes from the impact of changes in the price-to-earnings (P/E) ratio. [...] over a long time span, the impact of investment returns trump the impact of speculative returns.

By paying close attention to the price you pay for a stock, you minimize your speculative risk, which helps maximize your total return.

The most basic ratio of all is the P/S ratio, which is the current price of the stock divided by sales per share. The nice thing about the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings.

The P/S ratio has one big flaw: Sales may be worth a little or a lot, depending on a company's profitability.

Although the P/S ratio might be useful if you're looking at a firm with highly variable earnings – because you can compare today's P/S with a historical P/S ratio – it's not something you want to rely on very much. In particular, don't compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.

Another common valuation measure is price-to-book (P/B), which compares a stock's market value with the book value (also known as shareholder's equity or net worth) on the company's most recent balance sheet. The idea here is that future earnings or cash flows are ephemeral, and all we can really count on is the net value of a firm's tangible assets in the here-and-now.

When the market was dominated by capital-intensive firms that owned factories, land, rail track, and inventory – all of which had some objective tangible worth – it made sense to value firms based on their accounting book value. After all, not only would those hard assets have value in a liquidation, but also they were the source of many firms' cash flow. But now, many companies are creating wealth through intangible assets such as processes, brand names, and databases, most of which are not directly included in book value.

Another item to be wary of when using P/B to value stocks is goodwill, which can inflate book value to the point that even the most expensive firm looks like a value. When one company buys another, the difference between the target firm's tangible book value and the purchase price is called goodwill, and it's supposed to represent the value of all the intangible assets – smart employees, strong customer relationships, efficient internal processes – that made the target firm worth buying. Unfortunately, goodwill often represents little else but the desperation of the acquiring firm to buy the target before someone else did, because acquiring firms often overpay for target companies. Be highly skeptical of firms for which goodwill makes up a sizable portion of their book value.

A company that's trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels, and growth rates, all of which affect the P/E ratio. All else equal, it makes sense to pay a higher P/E for a firm that's growing faster, has less debt, and has lower capital reinvestment needs.

In general, comparing a company's P/E with industry peers or with the market has some value, but these aren't approaches that you should rely on to make a final buy or sell decision. However, comparing a stock's current P/E with its historical P/E ratios can be useful, especially for stable firms that haven't undergone major shifts in their business. If you see a solid company that's growing at roughly the same rate with roughly the same business prospects as in the past, but it's trading at a lower P/E than its long-term average, you should start getting interested.

Because risk, growth, and capital needs are all fundamental determinants of a stock's P/E ratio, higher growth firms should have higher P/E ratios, higher risk firms should have lower P/E ratios, and firms with higher capital needs should have lower P/E ratios.

When you're looking at a P/E ratio, you must be sure that the E makes sense. If a firm has recently sold off a business or perhaps a stake in another firm, it's going to have an artificially inflated E, and thus a lower P/E. Because you don't want to value the firm based on one-time gains such as this, you need to strip out the proceeds from the sale before calculating the P/E.

Don't rely on any single valuation metric because no individual ratio tells the whole story. Apply a number of different valuation tools when you're assessing a stock.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

Alternative to Discounted Cash Flow Method

What do you use if you don't want to or can't use the discounted cash flow (DCF) method of valuing a stock?  

There are other methods for valuing a stock (not valuing the company).  The most popular alternative uses various multiples to compare the price of one stock to a comparable stock.

The price earnings ratio (P/E) is the most popular multiple for these comparisons.

You can use the P/E formula to find the price based on comparable stocks.

For example, three stocks in a particular industry had an average P/E of say 18.5.  If another stock ABC in the same industry had earnings of $2.50 per share, you could calculate a stock price of $46.25 per share (= 2.5 x 18.5).  This is just an approximation, but it should put stock ABC on a comparable basis with the other three stocks in the same industry.



This strategy has several flaws.

1.  The P/E is not always the most reliable of value gauges.
2.  The process depends on the three comparables being priced correctly and there is no guarantee of that.
3.   Its biggest flaw is that the process tells you nothing of the future value of the company or the stock.

If you use this method, and many investors do, you will need to watch the stock more closely and continually measure it against comparables.  However, it does not require you to estimate anything or consider multiple variables, which is why it is so popular.

This method is best used for a quick decision on whether the stock is under-priced or over-priced.
Although you can arrive at a stock price based on the P/E formula, it is not nearly as accurate as the DCF method.



You can also use other key ratios in valuation.

These include the followings:
1.  Price/Book - Value market places on book value.
2.  Price/Sales - Value market places on sales.
3.  Price/Cash Flow - Value market places on cash flow.
4.  Dividend Yield - Shareholder yield from dividends.



So, which method should you use - DCF or multiples?

In the end, you will have to decide which method is for you.

There is no rule against using both.

Whether you calculate your own DCFs or use the estimates from others, reputable websites or analysts estimates, make sure you have the best guess available on the variables the formula needs.

Either way, make a conscious decision to buy a stock based on the valuation method of your choice and not a "feeling" for the stock.

QUICKIES: Seven investment myths you should not fall for

Text: Prerna Katiyar | ET Bureau

Pick this stock, it's trading at 52-week low.' 'That stock is a multi-bagger, trading at such a low PE.' 'Penny stocks make fortunes while stocks trading below book value are a sure pick for making quick bucks.'

Haven't we all heard such statements at some point in our lives? If you are one of those who believe in such assertions, read on. For, these are among the many myths in investing.



Here we list seven of them


Myth No 1: Stocks trading below book value are cheap

Book value (BV) is the actual worth of a stock as in a company's books/balance sheet, or the cost of an asset minus accumulated depreciation.

BV depends more on historical cost and depreciation and often has little correlation to the current share price.

Shares of industries that are capital intensive trade at lower price/ book ratios, as they generate lower earnings. On the other hand, those business models that have more human capital will fetch higher earnings and will trade at higher price/book ratios.

"Price/book (ratio) of below 1 may be cheap but one should see other aspects such as earnings forecast, guidance, management and debt on the books of the company ," says Angel Broking's equity derivatives head Siddarth Bhamre.


Myth No 2: Stocks trading at low P/E are under-valued

Price to earning ratio (P/E) is one of the most talked about ratios in the market. This is based on the theory that stocks with low P/Es are cheap.

However, P/E alone doesn't tell much about the stock price. P/E multiples may be a quick way to value a stock but one should look at this in correlation with expected growth earnings, the risk factors involved, company's performance and growth potential .

"This is surely a myth. It is also an indication of uncertain future earning of the stock concerned," says Birla Sunlife Mutual Fund CEO A Balasubramanian.

The idea behind dividing price with earnings is to create a levelplaying field where some kind of comparison can be made between high- and low-priced stocks.

Since P/E ratios vary across sectors, with growth stocks consistently trading at higher P/E, one can only compare the P/E ratio of a stock to the average P/E ratio of stocks in that sector.


Myth No. 3: Penny stocks make good fortunes

Penny stocks by nature are lowpriced , speculative and risky because of their limited liquidity, following and disclosure.

If it's easy to invest in penny stocks - as here you shell out much less money per share than you would require for a blue-chip firm - it's also easy to lose.

Says Bhamre, "Fortune can be made by high-denomination stocks also. Denomination has nothing to do with the rationale for picking a stock. Generally , retail investors are fond of stocks that are at sub- Rs 100 levels. But there may be stocks that may be trading in Rs 1,000-plus price but may well be cheap. Clarity on earnings is more important here. Anytime, I would be more comfortable buying an ICICI Bank (currently trading at Rs 1,038) than an IFCI at Rs 45. One should look at earnings visibility."


Myth No. 4: The worst is over in the stock market

Timing the market, a common strategy among investors, means forecasting and that should best be left to astrologers and tarot readers.

If one has done one's valuation studies, one shouldn't worry about timing the market. No one had predicted the bull run would take the Sensex from a level of 10,000 in February 2006 to over 21,000 in January 2008 - just as no one had any idea of the following crash, which saw the same index plummeting to 9,000 in March 2009.

"Timing the market is more of a gut feeling. It's more on the basis of perception, as there is no such thing (that the worst is over) when the future is uncertain. One can never surely time the market. The worst is over is more of a probability than a certainty. Timing the market is very difficult as market is driven not just by earnings but also by sentiments ," says Balasubramanian.


Myth No 5: Stocks that give high dividends are the best bet

This comes from the notion that regular dividends are extra income in the shareholder's hand. This may not always be true.

While a company may be making decent payouts every year, the share price appreciation may not be comparatively high. Before investing in companies paying high dividends, it's important to analyse if the company is reinvesting enough profit to grow its earnings consistently.

Says Brics Securities' research VP Sonam Udasi: "It's not dividend that matters but the yield. For eg, a company may pay a 100% or even a 300% dividend on a stock with face value of Rs 10.

So, the investor may receive Rs 10 or Rs 30 per share when the stock may be currently trading at Rs 800 or Rs 1000. This would translate into an yield of 1% or 3% only. Also, such companies may not necessarily be reinvesting their earnings in the business to generate future earnings and so there may be no stock movement. The dividend may be high but the EPS and growth per se may be constant."



Myth N0 6: Index stocks are the best stocks

If this was true, most investors would safely park their money in such stocks in anticipation of maximum profit without looking out for other value stocks.

Most indices are a collection of stocks with the highest market cap. Take, for eg, the Sensex.

Companies that make up the index are some of the largest, with stocks that are highly traded based on their free-float.

"Index stocks may not necessarily be the best stocks as they are mostly based on market-cap or free-float of the company and not earnings. This doesn't mean that all stocks of the Sensex are highearning stocks. One must take a stock-by-stock call," says Balasubramanian of Birla Sun Life Mutual Fund.

The stock price of a company depends on its earnings. One can find high-earning stocks outside the key indices as well, he says. The risk is certainly less with index stocks as they are well researched and leaders in their respective sectors, but, again, the margins may not be very high. So it's better to keep your eyes open to other stocks, too.



Myth No 7: Stocks trading at 52-week low are cheap

Says Udasi: "There may be a time in the economic cycle when a blue-chip stock may hit a 52-week low.

But the first thing that should come to one's mind is why did the stock hit the 52-week low.

There must be something fundamentally wrong with the stock if it has hit a 52-week low, and chances are they may hit a new 52-week low.

52-week low in itself guarantees nothing. If at all one is picking stocks at 52-week lows, they should have a long-term horizon so that when the economic cycle turns, the stock is able to recover."

Needless to say, quality matters most while buying any stock.


http://economictimes.indiatimes.com/seven-investment-myths-you-should-not-fall-for/quickiearticleshow/9438662.cms

****Investment Valuation Ratios

This ratio analysis tutorial looks at a wide array of ratios that can be used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its valuation.

However, when looking at the financial statements of a company many users can suffer from information overload as there are so many different financial values. This includes revenue, gross margin, operating cash flow, EBITDA, pro forma earnings and the list goes on. Investment valuation ratios attempt to simplify this evaluation process by comparing relevant data that help users gain an estimate of valuation.

For example, the most well-known investment valuation ratio is the P/E ratio, which compares the current price of company's shares to the amount of earnings it generates. The purpose of this ratio is to give users a quick idea of how much they are paying for each $1 of earnings. And with one simplified ratio, you can easily compare the P/E ratio of one company to its competition and to the market.

The first part of this tutorial gives a great overview of "per share" data and the major considerations that one should be aware of when using these ratios. The rest of this section covers the various valuation tools that can help you determine if that stock you are interested in is looking under or overvalued.

Table of Contents

1) Investment Valuation Ratios: Introduction

2) Investment Valuation Ratios: Per Share Data

3) Investment Valuation Ratios: Price/Book Value Ratio

4) Investment Valuation Ratios: Price/Cash Flow Ratio

5) Investment Valuation Ratios: Price/Earnings Ratio

6) Investment Valuation Ratios: Price/Earnings To Growth Ratio

7) Investment Valuation Ratios: Price/Sales Ratio

8) Investment Valuation Ratios: Dividend Yield

9) Investment Valuation Ratios: Enterprise Value Multiple

Short cuts for finding value

Companies and shares are worth the present value of the future cash they can generate for their owners.  This is a rather simple statement, and yet in practice, valuing companies is not so straightforward.

As the famous economist John Maynard Keynes put it, it's better to be vaguely right than precisely wrong, and the better bet is to stick to a few simple valuation tools.  Here are some ways to value companies or shares:

1.  Discount cash flow method.

2.  Asset-based valuation tools.

• Price/Book Value
• Graham's Net Current Asset approach

3.  Earnings-based valuation tools.

• PE ratio

4.  Cash flow-based valuation tools

• DY
• FCF Yield

These different valuation tools each have their own strengths and weaknesses.

• The price-to-book ratio tends to work best with low-quality businesses on steep discounts.  
• The PER tends to work best with high-quality growth companies.  
• The dividend yield and free cash flow yield tend to be suited to mature businesses generating steady returns.

But in every case, you'll probably get closest to the truth by looking at all the different measures.

Also, only invest in good quality businesses.

Book value is a good proxy for the value of a banking stock.

Because banks' balance sheets consist mostly of financial assets with varying degrees of liquidity, book value is a good proxy for the value of a banking stock.  Assuming the assets and liabilities closely approximate their reported value, the base value for a bank should be book value.  

• For any premium above the book value, investors are paying for future growth and excess earnings.  
• Seldom do banks trade for less than book, but if they do, the bank's assets could be distressed.  
• Typically, big banks have traded in the two or three times book range over the past decades; regionals have often traded for less than that.

A solid bank trading at less than two times book value is often worth a closer look.

• Remember, there is almost always a reason the bank is selling at a discount, so be sure you understand the risks.  
• On the other hand, some banks are worth three times book value or more, but we would exercise caution before paying that much.  

Bank stocks are volatile creatures, and you can find good values if you're patient - especially because even the best banks will generally be hit hard when any high-profile blowup occurs in the financial services sector.  Lining up several banks for a relative P/B valuation isn't as good as putting together a discounted cash flow model, but for this industry, it can be a reasonable approximation of the value of the business.

These metrics should serve as a starting point for seeking out quality bank stocks.  Overall, we think the best defense for investors who want to pick their own financial services stocks is

• patience and 
• a healthy sense of skepticism.  

Build a paper portfolio of core companies that look promising and learn the businesses over time.  Get a feel for

• the kind of lending they do, 
• the way that risk is managed, 
• the quality of management, and 
• the amount of equity capital the bank holds.  

When an opportunity presents itself - and one always does - you'll be in a much better position to act.

Measurement in the Balance Sheet

Book values measurement determines the price-to-book ratio. To evaluate the price-to-book ratio, we must understand how book values are measured.

The values of some assets and liabilities are easy to measure, and the accountant does so. He applies mark-to-market accounting, thus recording these items on the balance sheets at fair value (in accounting terms). These items do not contribute to the premium over book value.

But for many items, the accountant does not, or cannot, mark to market. He applies historical cost accounting. U.S. GAAP gives measurement rules for items commonly found on balance sheets, with those carried at fair value and historical cost indicated. International accounting standards broadly follow similar rules.

-----

Example:

Company A Balance Sheet

Cash and cash equivalent $7.764 million
Short term investments $208 million
Long term investments (mainly interest bearing debt securities) $1,560 million.

Comment:  A market value is usually available for these securities, so they can be marked to market.

Accounts payable $11,492 million
Long term debt $362 million

Comment:  The accounts payable is close to market value and, while the long-term debt is not marked to market, its book value approximates market value unless interest rates change significantly.

So all these items above do not contribute to price premium over book value.

Net accounts receivable $5,961 million
Financing receivables $1,732 million
Accrued expenses $4,323 million
Other "liabilities" $2,070 million

Comment:  All the above 4 items involve estimates, but if these are made in an unbiased way, these items, too, are at fair value.

Company A
2,060 outstanding shares
Market Price $20 per share.
Market value of these shares: $41,200 million.
Book value $3,735 million
Therefore the market premium was $37,465 million.

Comments:
The market saw $37,465 million of shareholder value that was not on the balance sheet.
And it saw $37,465 million of net assets that were not on the balance sheet.
With 2060 million shares outstanding,

• the book value per share (BPS) was $1.81 and
• the market premium was $18.19 per share.

How does one account for Company A's large market premium of $37,465 million over the book value of its equity?

The large market premium of $37,465 million over the book value of its equity arises largely from

• tangible assets, recorded at (depreciated) historical cost, and
• unrecorded assets.

The latter are likely to be quite significant. Company A's value, it is claimed, comes not so much from tangible assets, but from

• its innovative "direct-to-customer" process,
• its supply chain, and
• its brand name.

None of these assets are on its balance sheet.

• Nor might we want them to be.
• Identifying them and measuring their value is a very difficult task, and we would probably end up with very doubtful, speculative numbers.

The Market Price-to-Book and Intrinsic Price-to-Book Ratio

The balance sheet equation corresponds to the value equation. 

 

The value equation can be written as:

 

Value of the firm = Value of equity + Value of debt
or
Value of equity = Value of firm - Value of debt

 

• The value of the firm is the value of the firm's assets and its investments.
•  The value of the debt is the value of the liability claims.

 

The value equation and the balance sheet equation are of the same form but differ in how the assets, liabilities, and equity are measured.

 

The measure of stockholders' equity on the balance sheet,l the book value of equity, typically does not give the intrinsic value of what the equity is worth. 

• Correspondingly, the net assets are not measured at their values. 
• If they were, there would be no analysis to do!  It is because the accountant does not, or cannot, calculate the intrinsic value that fundamental analysis is required.

The diffeence between the intrinsic value of equity and its book value is called the intrinsic premium:

 

Intrinsic premium = Intrinsic value of equity - Book value of equity

 

The difference between the market price of equity and its book value is called the market premium:

 

Market premium = Market price of equity - Book value of equity

 

If these premiums are negative, they are called discounts (from book value).  Premiums sometimes are referred to as unrecorded goodwill because someone purchasing the firm at a price greater than book value could record the premium paid as an asset, purchased goodwill, on the balance sheet; without a purchase of the firm, the premium is unrecorded.

 

Premiums can be calculated for the total equity or on a per-share basis.

 

-----

 

Example:
Company A
2,060 outstanding shares
Market Price $20 per share.
Market value of these shares: $41,200 million.
Book value $3,735 million
Therefore the market premium was $37,465 million.

 

Comments: 
The market saw $37,465 million of shareholder value that was not on the balance sheet.
And it saw $37,465 million of net assets that were not on the balance sheet.
With 2060 million shares outstanding,

• the book value per share (BPS) was $1.81 and
• the market premium was $18.19 per share.

-----

 

 

The ratio of market price to book value is the price-to-book ratio or the market-to-book ratio.

 

The ratio of intrinsic value to book value is the intrinsic price-to-book ratio. 

 

• Investors talk of buying a firm for a number of times book value, referring to the P/B ratio. 
• The market P/B ratio is the multiple of book value at the current market price. 
• The intrinsic P/B ratio is the multiple of book value that the equation is worth. 
• An investor will spend considerable time estimating intrinsic price-to-book ratios and asking if those intrinsic ratios indicate the the market P/B is mispriced.

Historical Perspective of P/B ratios

 

In asking such questions, it is important to have a sense of history so that any calculation can be judged against what was normal in the past.  The history provides a benchmark for our analysis.  

• P/B ratios in the 1990s were high relative to historical averages, indicating that the stock market was overvalued.  
• The medican P/B ratios (the 50th percentile) for the U.S. listed firms were indeed high in the 1990s - over 2.0 - relative to the 1970s. 
• But they were around 2.0 in the 1960s. 
• The 1970s experienced exceptionally low P/B ratios, with medians below 1.0 in some years.

 

What causes the variation in ratios? 

• Is it due to mispricing in the stock market?
• Is it due to the way accountants calculate book values?

 

The low P/B ratios in the 1970s certainly preceded a long bull market.

• Could this bull market have been forecast in 1974 by an analysis of intrinsic P/B ratios?
• Were market P/B ratios in 1974 too low? 
• Would an analysis of intrinsic P/B ratios in the 1990s find that they were too high?

 

Company A's P/B of 11.0 in 2008 looks high relative to historical averages.

• Was it too high?

 

The fundamental investor sees himself as providing answers to these questions.  He estimates the intrinsic value of equity that is not recorded on the balance sheet. 

 

You can screen for firms with particular levels of P/B ratios using stock screener from links on the Web.

Using Book Value in Making Investment Decisions

Going by the Book
Using Book Value in Making Investment Decisions

by Virginia B. Morris



Heading the list of questions investors sometimes struggle to answer is the perennial “What’s this stock worth?” The response is never simple, since there are several ways of assessing value. One of the most reliable ways is to use a combination of ratios, also called multiples. The BetterInvesting methodology employs the price-earnings ratio, which compares the stock’s price with its earnings per share.


Investors also measure a company’s stock price in relation to entries on its balance sheet. One of those ratios is price-to-book, or a stock’s market price divided by book value per share.

A stock’s book value, also called its net asset value and sometimes its shareholder equity, is key to figuring its price-to-book. Even if you don’t use price-to-book in your analysis, you should understand what book value is because it’s part of the calculation of return on equity, a key measure of management performance on the Stock Selection Guide.

Basically, book value is the company’s assets minus its liabilities, divided by the number of outstanding shares. The liabilities include the obligations the company has to its bondholders and preferred stockholders.

Some stock research companies report price-to-book over time, such as 10 years, as well as percentage growth in book value. You can also calculate book value on your own, using the company’s financial reports. You find net assets by subtracting the company’s short- and long-term liabilities from its assets. Then divide net assets by the number of outstanding shares to find the per-share results.

Two cautions: Check what’s being counted as assets. If intangibles such as goodwill or brand value are being included, those amounts should be subtracted to determine net assets. Also, as a related point, book value is more meaningful for companies that have actual physical assets that can be valued.

What P/B Tells You

Book value is important because it can help you determine whether a stock you may be interested in is underpriced and therefore potentially worth purchasing.

If the market price of a stock and its book value are the same, its price-to-book value is said to be 1. In that case, investors are paying exactly the value of the company’s reported assets. If the ratio is more than 1, they’re paying for past performance or what they anticipate the company’s future performance will be. That’s quite common, especially for companies with strong earnings.

Conversely, a ratio of less than 1 may indicate investors aren’t convinced that the assets the company is reporting are credible. It also may signal that the company’s performance has been disappointing or the stock is out of favor with investors for some other reason. Questionable valuation of assets, of course, is a reason to steer clear of the stock, while the latter instance, which is remediable, may be a reason to consider buying.

One for the Books

Both book value and price-to-book change constantly as a stock’s market value and the number of its outstanding shares continually fluctuate. As a result, these numbers are “snapshots” that report the present but can’t predict the future.

If you’re just beginning to investigate a stock, however, book value is a useful benchmark to watch as you track the issuing company over time. That’s especially true if you’re looking at a number of stocks in the same sector or industry, since the price-to-book value can be strikingly similar across companies of varying sizes in the same industry. One that’s out of sync may be a stock that merits closer attention.

As you study a stock, putting its price-to-book and percentage growth in book value in a historical context can be helpful in establishing a target price you’re o use this ratio want a sense of where the current price fits in relation to earlier highs and lows in helping them pinpoint a price range that would allow them to realize a satisfactory return.

Putting Value in Perspective

Book value and a price-to-book ratio, by themselves, should never be the single basis for making an investment decision, any more than the ROE, EPS or P/E should be. But each can be a valuable addition to your research toolbox, and used in combination they can provide a valid foundation for choice.



Virginia B. Morris is the Editorial Director for Lightbulb Press.


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