P/B is Overrated
Robbert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The price of a security divided by its book value is, as a valuation metric, overvalued. Many stock valuation models are (at least partly) based on this ratio, but this does not mean that a causal relationship exists between high future returns and low P/B ratios. There are many factors that influence the usefulness of the P/B ratio when analyzing non-financial publicly traded companies.
Book value is not that important, as the assets of a company are quite fixed and generally can’t be sold without hurting future earnings. However, if there are assets that can and will be quickly returned to investors, these should be abducted from the security’s price in its analysis. If the returning of those liquid assets would hurt the stability of the company, they should not be accounted for as liquid in the mind of an investor. An example, in a CAPS pitch someone said this about GM (NYSE: GM): “Cash-debt … you’re effectively paying $9.73 … That's a P/E of 2.12.”. The cash GM has is desperately needed to keep the credit rating within the investment grade zone. GM eventually needs this cash to pay its pension liabilities and much more. Also, some cash is used as working capital and is effectively fixed. I believe the cash that is now in GM’s pockets create an essential buffer zone against any adversity it may encounter and will never be returned to shareholders. It is a convenient thought though, that because of this amount of cash, a greater part of future cash flows can be returned to investors.
To investors, P/B can be very relevant for a company that’s in danger of going bankrupt. Sadly, book value is not always what is seems to be, Genco Shipping (NYSE: GNK) for example has a P/B of 0.13. To me, there is no doubt that this figure is not representative for the current state of the company. At present, the ships on its balance sheet are worth substantially less than their book value. And in this case it is important to know the actual book value, as Genco’s continuity is uncertain.
An example of apparent usefulness of the P/B ratio is Facebook (NASDAQ: FB) at the time of its IPO, with a very high P/E of >80 and a P/B ratio of >11. In the case of Facebook, the book value had nothing to do with this, it was overvalued based on ROE, EPS and (overestimated) future growth.
Still, the case for P/B ratio remains strong, as many studies has shown a fairly strong and consistent relationship between P/B ratio and future returns. Perhaps the best model for explaining returns which uses the Book to market value is the Fama-French three-factor model.
The fact that stocks with a low P/B ratio historically yielded a greater return to investors might be explained by the mere fact that those companies had temporarily depressed market caps, and were cheap relative to the times before and after undervaluation. Off course, P/B can indicate cheapness as historically book values generally don’t vary that much, but stock prices do.
I believe that the P/E ratio and projected future free cash flow are much more useful in determining a security’s value than the P/B ratio is. As estimated future cash flows are difficult to capture and using P/E is very impractical (e.g. it can be negative, profits can briefly be very low), book value is the best general way of scientifically explaining past and predicting future returns. But mostly it’s better to use common sense when looking at book values.
Return on capital
Occasionally, a high P/B ratio can be a very positive sign. An example: let us consider to companies x and y. Both have a P/E of 20, as well as the same market cap, revenue, risk etc. The only difference is the book value, company x has a p/b ratio of 1.25 and company y has a P/B of 2. From this it follows that company x has a Return on Equity (ROE) of 6.25%; company y has a ROE of 10%. Imagine that the companies both have an opportunity to grow their business by 5% each year forever. Company x would have to invest 80% of its earnings to get there while company y would only have to invest 50% of its earnings. In the next 5 years company x is able to return 6.9% of its initial market cap. to shareholders while y could pay out 15.2%. This difference of 120% is huge and not be ignored by investors. This is the story of IBM (NYSE: IBM), with a P/B of over 10 some people say it is overvalued. But to Warren Buffet (a legendary value investor) this great company is a lean mean cash machine with a ROE of >70%. Fun fact: IBM’s capital investments decreased in the past 5 years by 2.4% on average while EPS have grown by 14.5% annually.
Investor89 owns shares of International Business Machines and General Motors Company. The Motley Fool owns shares of Facebook and International Business Machines. Motley Fool newsletter services recommend Facebook and General Motors Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.