When you're an investor, the last thing you want is to pay too much for a stock or miss a bargain price. This is where value investing comes into play.
In value investing, investors pick stocks that are cheap but fundamentally strong. Among the various ratios to identify value stocks, investors often look at price-to-earnings (P/E) and price-to-sales (P/S). While P/E is the ratio of annual earnings per share to stock price, P/S is stock price divided by sales per share.
However, the underrated price-to-book ratio (P/B ratio) can also do wonders if used properly to identify low-priced stocks with high-growth prospects. The P/B ratio is calculated as below:
P/B ratio = market capitalization / book value of equity
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 total assets of a company. In most cases, this would equate to the 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 the book value.
Explaining the P/B Ratio
By comparing 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 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.
But there is a caveat. A P/B ratio less than one can also mean that the company is earning weak or even negative return on its assets, or the assets are overstated, in which case the stock should be shunned because it may be destroying shareholder value. Conversely, the stock’s share 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 its 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 large R&D expenditures or high-debt companies or service companies or those with negative earnings.
In any case, the P/B is not particularly relevant as a standalone number. One should also analyze other ratios like P/E, P/S, and debt to equity before arriving at a reasonable investment decision.
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 ratio links the 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 a bright earnings growth prospect.
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 Style Score equal to A or B: Our research shows that stocks with a Value Style Score of ‘A’ or ‘B’ when combined a Zacks Rank #1 or 2 offer the best opportunities in the value investing space.
Here are five of the seven stocks that qualified the screening:
Xerox Corporation (XRX - Analyst Report) is a leader in the development, manufacture, marketing, servicing and financing of document equipment across the world. The stock currently has a Zacks Rank #2 and a Value score of ‘A’. The company’s projected 3–5 year EPS growth rate is 10.0%.
Korea Electric Power Corp. (KEP - Analyst Report) , also known as KEPCO, is an integrated electric utility engaged in the generation, transmission and distribution of electricity as well as development of electric power resources in South Korea. This Zacks Rank #1 stock has a 3–5 year EPS growth rate of 25% and a Value score of ‘A’. You can see the complete list of today’s Zacks #1 Rank stocks here.
PennyMac Financial Services, Inc. (PFSI - Snapshot Report) is a financial services company with a projected 3–5 year EPS growth rate of 7.50%. Currently, PennyMac Financial Services carries a Zacks Rank #2 and a Value score of ‘B’.
United Therapeutics Corporation (UTHR - Analyst Report) The biotechnology company currently has a Zacks Rank #2 and a Value score of ‘B’.
Magna International Inc. (MGA - Analyst Report) is a leading manufacturer and supplier of automotive components. The company carries a Zacks Rank #2 and a Value score of ‘A’. Its projected 3–5 year EPS growth rate is 11.74%.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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