Thursday, October 23, 2008

Investor Mood Swings

When the market is pessimistic, one can buy good companies at discounts to their intrinsic values. What's a good way to tell if the market is pessimistic about a stock you're interested in? As we saw in the Chapter 7 summary of The Investment Zoo, Stephen Jarislowski suggests comparing a company's current P/E with its historical P/E to see if it trades at depressed levels. As seen here, we did this comparison for Coca-Cola (KO) over the last several decades to get an idea of where it currently trades.

However, for some firms, P/E is not the best measure of value. Consider companies or industries with very cyclical earnings. Since earnings fluctuate, P/E values can be distorted and thus can't be relied upon to provide meaningful data. Another useful method to compare a company's market valuation to its historic levels is using the price to book (P/B) values. P/B values are often considered useful for the financial industry, where the market value of a firm is heavily related to the value of its equity. As an example, here's a look at historical P/B levels for several banks (JP Morgan, Citibank, Bank of America, and Wachovia which is in the midst of being taken over):

We see that throughout the late 70s and early 80s, one could buy banks for less than the book value of their common equity. Once again, we see banks approaching those valuation levels.

Of course, one has to be cautious when considering this data. If book values are to drop (as they have been in this industry of late), then the P/B values above are currently overstated. Also, as we discussed here, the use of leverage in the banking industry makes the value of equity particularly difficult to accurately measure. Nevertheless, these weaknesses of using P/B for the banking sector shouldn't discourage you from making historical P/B comparisons for companies in industries with stable book values and medium to low use of debt levels.

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