Though value investors have tried various ways to identify stocks that are trading at a discount to their actual value, spotting a discounted stock is quite difficult.
You are a growth investor when you buy a share with a tremendous growth potential. However, value investing is different and involves picking stocks that are priced below their intrinsic value. Ironically, it requires investors to embrace stocks that are under the radar. Price-to-earnings (P/E) and price-to-book value (P/B) ratios are favorite tools of value investors.
Though P/E is a more popular financial metric, P/B ratio is also emerging as a convenient tool for identifying low-priced stocks that have high growth prospects. The ratio is used to compare a stock’s market value/price to its book value.
The P/B ratio is calculated as below:
P/B ratio = market price per share/book value of equity per share
Now let us understand the concept of book value.
Understanding 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 its liabilities.
It is calculated by subtracting total liabilities from the total assets of a company. In most cases, this equates to the common stockholders’ equity on the balance sheet. However, depending on the company’s balance sheet, intangible assets should also be subtracted from the 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 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.
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 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 of the 11 stocks that qualified the screening:
Mallinckrodt Public Limited Company (MNK - Free Report) , a specialty biopharmaceutical company, currently has a Zacks Rank #1 and a Value Score of A. It has a 3-5 year EPS growth rate of 12%. You can see the complete list of today’s Zacks #1 Rank stocks here.
Bayer Aktiengesellschaft (BAYRY - Free Report) , a German pharma giant, currently has a Zacks Rank #2 and a Value Score of A. It has a 3-5 year EPS growth rate of 10.4%.
PVH Corp (PVH - Free Report) , a leading apparel company, has a Zacks Rank #2 and a Value Score of B. It has a 3-5 year EPS growth rate of 12.9%.
Daqo New Energy Corp. (DQ - Free Report) manufactures and sells high-quality polysilicon to photovoltaic product manufacturers. The company has a projected 3-5 year EPS growth rate of 29%. It currently has a Zacks Rank #2 and a Value Score of A.
General Motors Company (GM - Free Report) , a leading global automotive company, currently has a Zacks Rank #2. It has a 3-5 year EPS growth rate of 8.5% and a Value Score of A.
Beacon Roofing Supply, Inc. (BECN - Free Report) , a distributor of building materials, has a projected 3-5 year EPS growth rate of 21%. CAI International currently has a Zacks Rank #2 and a Value Score of B.
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