Tuesday, July 7, 2009

Price and Book Volatility

Last week, we looked at the historical price to book value of Melcor, and noticed that it sells today near historic lows. While this may suggest a buying opportunity to some, many would argue that varying levels of price to book ratios are appropriate based on changing expectations for the value of Melcor's book value. For example, if real estate prices are expected to increase, price to book values should be higher, since the company will experience gains as it sells land for higher than it is booked. Conversely, if prices are expected to contract, writedowns to book value should be expected, and therefore investors should only purchase at a discount to book value.

By separating out the components of P/B, we can get a good idea of whether this is what's driving the dramatic changes in Melcor's P/B (values in $millions):

Clearly, whether times are good or bad, Melcor's book value does not change dramatically. Even through this most recent downturn, which hit Western Canadian real estate prices hard due to their local economic exposure to commodity prices, Melcor's book value retreated only marginally or stayed flat. Through the commodity and real estate price run up from 2004 to 2007, book values did increase more than normal (as gains were realized), but not nearly enough to justify the dramatic price increases which made this stock fiercely overpriced!

Indeed, it would appear that while the market appears able to predict the direction of book values, it overreacts both when book values are rising and when they are not. This theme is not specific to Melcor. As we saw when we looked at several major US homebuilders, during times like these the market will often offer real estate at large discounts which are more than enough to offset any upcoming writedowns.

Determining whether a company or industry is historically cheap by looking at P/B values is not limited to home builders. We have previously seen how the relative valuations of banks can also be judged on this basis.

Disclosure: Author has a long position in MRD


Unknown said...

Interesting post. MRD is my 2nd biggest position at about 20% of my portfolio at a cost basis of $3.60.

This was a natural for me. Since I am an Edmonton resident I can see first hand the quality of their assets.

Slicing up the pie on the timing of their land purchases, I came up with a NAV in the $15-$20 range. Add a 100% catalyst of fair value being realized in 2011 and you've got a safe inflation hedged stock with good potential.

Saj Karsan said...

That's a heck of a price you bought in at.

Go Oilers!

mikec said...

Garrett what is the catalyst that will present itself in 2011?