It’s not an easy job to find value stocks. Being aware of a company's key financial numbers, like earnings per share and sales growth, can help investors identify stocks that are trading for less than what they're worth. However, a proper analysis of the fundamentals with the help of a number of metrics is required to determine whether a stock is a good bargain or not.
For narrowing down the list of undervalued stocks, price to earnings (P/E) and price to sales (P/S) are the first ratios that come to an investor’s mind. However, price-to-book ratio (P/B ratio), though underrated, is also an easy-to-use valuation tool for identifying low-priced stocks with high-growth prospects.
The P/B ratio is calculated as below:
P/B ratio = market capitalization / book value of equity
Now let us understand the concept of book value.
What is Book Value?
There are several ways by which book value can be defined. Book value is the total value that would be left over, according to the company’s balance sheet, if it goes bankrupt immediately. In other words, this is what shareholders would theoretically receive if a company liquidates all its assets after paying off all its liabilities.
It is calculated by subtracting total liabilities from the total assets of a company. In most cases, this equates to common stockholders’ equity on the balance sheet. However, depending on the company’s balance sheet, intangible assets should also be subtracted from total assets to determine book value.
Understanding P/B Ratio
By comparing the book value of equity to its market price, we get an idea of whether a company is under- or overpriced. However, like P/E or P/S ratio, it is always better to compare P/B ratios within industries.
A P/B ratio of less than one means that the stock is trading at less than its book value, or the stock is undervalued and therefore a good buy. Conversely, a stock with a ratio greater than one can be interpreted as being overvalued or relatively expensive.
For example, a stock with a P/B ratio of 2 means that we pay $2 for every $1 of book value. Thus, the higher the P/B, the more expensive the stock.
But there is a caveat. A P/B ratio less than one can also mean that the company is earning weak or even negative returns on its assets, or that the assets are overstated, in which case the stock should be shunned because it may be destroying shareholder value. Conversely, the stock’s price may be significantly high — thereby pushing the P/B ratio to more than one — in the likely case that it has become a takeover target, a good enough reason to own the stock.
Moreover, the P/B ratio isn't without limitations. It is useful for businesses — like finance, investments, insurance and banking or manufacturing companies — with many liquid/tangible assets on the books. However, it can be misleading for firms with significant R&D expenditure, high debt, service companies or those with negative earnings.
In any case, the ratio is not particularly relevant as a standalone number. One should analyze other ratios like P/E, P/S and debt to equity before arriving at a reasonable investment decision.
Screening Parameters Price to Book (common Equity) less than X-Industry Median: A lower P/B compared with the industry average implies that there is enough room for the stock to gain. Price to Sales less than X-Industry Median: The P/S ratio determines how much the market values every dollar of the company’s sales/revenues — a lower ratio than the industry makes the stock attractive. Price to Earnings using F(1) estimate less than X-Industry Median: The P/E ratio (F1) values a company based on its current share price relative to its estimated earnings per share — a lower ratio than the industry is considered better. PEG less than 1: PEG links P/E ratio to the future growth rate of the company. PEG ratio portrays a more complete picture than the P/E ratio. A value of less than 1 indicates that the stock is undervalued and investors need to pay less for a stock that has bright earnings growth prospects. Current Price greater than or equal to $5: They must all be trading at a minimum of $5 or higher. Average 20-Day Volume greater than or equal to 100,000:A substantial trading volume ensures that the stock is easily tradable. Zacks Rank less than or equal to #2:Zacks Rank #1 (Strong Buy) or 2 (Buy) stocks are known to outperform irrespective of the market environment. Value Score equal to A or B: Our research shows that stocks with a Value Score of A or B when combined with a Zacks Rank #1 or 2 offer the best opportunities in the value investing space.
Here are six out of the 16 stocks that qualified the screening:
PVH Corp. ( PVH Quick Quote PVH - Free Report) ,a leading apparel retailer, has a 3-5-year EPS growth rate of 18.0%. It currently has a Zacks Rank #2 and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Honda Motor Co., Ltd. ( HMC Quick Quote HMC - Free Report) is a leading manufacturer of automobiles and the largest producer of motorcycles in the world. It has a projected 3-5-year EPS growth rate of 21.8%. It currently has a Zacks Rank #1 and a Value Score of A. Adient plc ( ADNT Quick Quote ADNT - Free Report) , the world’s largest automotive seating supplier, has a projected 3-5-year EPS growth rate of 31.6%. It currently has a Zacks Rank #2 and a Value Score of A. Owens Corning ( OC Quick Quote OC - Free Report) , a world leader in building materials systems and composite solutions, has a projected 3-5-year EPS growth rate of 14.1%. It currently has a Zacks Rank #2 and a Value Score of A. Conns ( CONN Quick Quote CONN - Free Report) , a specialty retailer, has a Zacks Rank #1 and a Value Score of A. The company has a projected 3-5-year EPS growth rate of 23.0%. The Goldman Sachs Group ( GS Quick Quote GS - Free Report) , a leading global financial holding company, has a Zacks Rank #2 and a Value Score of B. The company has a projected 3-5-year EPS growth rate of 19.2%.
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