Tuesday, September 8, 2009

The Importance Of The Price to Book Metric

We discuss the Price to Book values of various stocks quite often on this site, but how useful a metric is it? From a logical standpoint, as a purchaser of a business (which is how we view all our stock purchases), a prudent buyer ensures - barring certain exceptional circumstances - that he does not pay too much more for a company than the value of its assets. In this way, he receives downside protection to a certain extent. Though book value is not a perfect measure of the value of a company's net assets, it does provide at least some level of a proxy for it.

That's all well and good in theory, but does this practice actually hold up against empirical data? Do stocks with low P/B values indeed outperform the market? There have been several studies that suggest that historically, stocks with lower P/B values have in fact outperformed, however, there are certain caveats to keep in mind.

One study that has gained industry credence was carried out by Bauman, Conover, and Miller. The authors used an international sample of stocks and divided them into quartiles based on P/B. They observed over the ten-year period of their study that the quartile of the lowest P/B stocks had mean returns of 18.1%, while those of the highest P/B had mean returns of 12.4%, representing an annual spread of 5.7%.

Based on this data, buying a basket of low P/B stocks may get you outstanding returns, but you may do even better if you can determine which of the low P/B stocks are worth purchasing and which are about to go bankrupt: the standard deviation of the returns for the lowest P/B stocks was 70 as compared to 57 for the highest P/B quartile, suggesting the low P/B space contained some big winners along with some big losers.

This is why looking for companies with low debt and good liquidity among issues trading at discounts to their book values can present great investment opportunities, some of which we discuss here.


pritchie said...

Could you provide a little more detail on exactly how you see the downside protection of buying below BV playing out?

Do you see it as a floor for the stock price itself? Or more of a psychological protection in knowing that you bought $1 for 50c?

Saj Karsan said...

Hi Pritchie,

There's no telling what the stock price will do, so the downside protection is from the perspective (that we like to take, as value investors) of a buyer of a private business: if the assets are of high quality, then even if business conditions are poor, the investor can still recover his initial investment in many cases, thus providing "downside protection".

Unknown said...

What do you think of MIR? I think it is a great value play based on Price to (tangible) book, as well as price to normalized earnings. I also like the way these guys allocate capital.

pritchie said...

That makes sense, thanks :)

When you say 'if business conditions are poor' are you assuming bankruptcy followed by liquidation?

Saj Karsan said...

Hi Turbo,

If I find anything interesting, I'll get back to you.

Hi Pritchie,

Bankruptcy would be an extreme situation, so what I generally mean is that if earnings are poor for a few quarters or a few years, the company can pay its bills and still has assets left over worth more than the stock value, thus leaving stock owners in a decent position even if things go badly.

Saj Karsan said...

Hi Turbo,

I agree with your points about capital allocation and P/B, but I find the earnings power very difficult to predict. No contracts, no fixed rates, just market forces on a highly volatile (price wise) commodity product...makes it tough to know what they will earn in the future.

Anonymous said...

I personally am not aware where-by investors have ever recouped their investment based on the quality of their assets. Can you, as a value investor point to relative examples that back your statement "if the assets are of high quality, then even if business conditions are poor, the investor can still recover his initial investment in many cases, thus providing "downside protection".

Does that not infer liquidation? If so I would love instances of where that happened after the bond holders and other creditors were paid.
Turb0kat, MIR looks like a mini Enron with a not-so-healthy revenue stream and their hedging activity.
Thanx, Paul

Saj Karsan said...

Hi Anon,

It doesn't have to be a liquidation situation, but it could. In many cases, quality assets can be sold to cover earnings shortfalls and/or keep the company around until costs can be reduced to adjust to a lower level of revenue.

Some examples are cited here: http://www.barelkarsan.com/2008/06/value-in-action.html