Education: Value Investing
Checking the Price-to-Book Ratio
A company with a low price-to-book ratio (P/B ratio) could signal a stock that is currently undervalued. But nothing is ever that simple, is it? A low P/B ratio could also mean that something is fundamentally wrong with that particular company.
The P/B ratio is frequently associated with value investing and it is very important that the value investor knows how to correctly decipher this widely-used ratio.
Price-to-Book Ratio Defined
The P/B ratio compares the market's valuation of a company to the value of that company as indicated on its financial statements. The ratio is calculated as follows:
Price to Book = Price per Share/Book Value of Equity
Price per share is relatively straight forward. But what exactly is book value of equity? This figure is defined as the difference between the book value of assets (cash, accounts receivable, inventory, equipment, etc.) and the book value of liabilities (loans, accounts payable, mortgages, etc). These figures can be found on a company’s balance sheet.
In other words, if you liquidated a company, this is what the leftover assets would be worth after paying off all the debts.
Undervalued or Underperformer?
P/B ratios of less than or equal to 3.0 typically catch the attention of value investors. However, a P/B ratio that meets these criteria can mean one of two things:
1) The stock is selling at a discount to its fair value. This may represent a perfect buying opportunity.
2) Something is fundamentally wrong with the company. You should avoid this stock like the plague.
The ratio should never be used as a stand-alone measure to pinpoint undervalued companies. If that were the case we would all be rich. When the P/B ratio is used in conjunction with a key growth indicator called return on equity (ROE), a clearer picture can be painted. But first, let’s cover some potential pitfalls associated with the P/B ratio.
No One Is Perfect—Including the P/B
Life is not all peachy when it comes to using the P/B ratio to find stocks that are potentially trading at a discount to their fair value. The measure has some limitations that investors need to be made aware of. Here are some of the most frequently cited:
The ratio usually works well only for companies with a good deal of assets on their books.
Intangible assets (goodwill, patents, etc.) are ignored by the book value calculation. Thus, it may not be very applicable to service firms.
Acquisitions can boost the book value and decrease the P/B ratio as a result.
Share repurchase programs lead to lower book values.
A Marriage Made in Heaven
A measure of how well a company is using reinvested earnings to generate additional earnings is a company’s ROE.
Return on Equity = Net Income/Shareholder’s Equity
When there is a large discrepancy between the ROE and the P/B ratio of a company, one should take notice. If a company’s ROE has been on the rise, so should its P/B ratio. This only makes sense because investors will bid up the price of a stock that produces a better ROE. Investors are attracted to profitable companies. I like companies that make money, don’t you?
What if a company has a low ROE and a high P/B? Growth, as represented by the P/B ratio, doesn’t look to be leading to a high level of profitability or shareholder value.
When looking for undervalued companies, it would be wise to add ROE to your screen.
Earnings Estimate Revisions and the Zacks Rank
You should not book all your hopes on low P/B ratios. As we stated in the article that covers PEG ratios, investors should never use any tool as a one-stop decision maker to uncover stocks that are potentially undervalued. It was mentioned earlier to examine a company’s ROE in addition to its P/B ratio. Taking this a step further, it is prudent to use a P/B ratio in conjunction with earnings estimate revisions and the Zacks Rank.
When a herd of analysts is convinced that earnings in future quarters are going to be higher than they previously anticipated for a company that they are covering, they are prompted to upwardly revise their profit expectations. Why are they acting in this manner? Something has caused them to have a more favorable outlook on the company. Regardless of the reason, earnings estimate revisions have a tremendous impact on stock prices and serve as the single best gauge of the future prospects of a company. And the best way to harness this phenomenon is through the Zacks Rank. (Learn more about the Zacks Rank).
Value investors should view this particular stock as currently undervalued relative to its future prospects. Rarely will a stock suffer a significant price decline in the face of improving fundamentals. Combine positive earnings estimate revisions and a healthy Zacks Rank with a P/B ratio of less than or equal to 3.0 and you have stumbled upon something special.
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