Friday, December 5, 2014

Price to Book value - How reliable is this metric?

Book Value is essentially a measure of all the company's assets minus liabilities. In other words, they are your equities portion in the financial statements.

Many times investors try to use the price-to-book metrics when deciding on whether to invest in a particular company. A quick way to look at this is through filtering of the price-to-book ratio. Anything above 1 means you are paying more for what they actually are. Surely we don't want to pay extra for something worth lesser than what they are.



But how reliable is this metric?

The truth is you probably need to take a closer look of how a company's book value is derived to help you decide on your investment purchasing decision. Depending on how you see them, they can be either a value trap or value play.

Value Trap

Imagine this scenario.

You have plenty of cash and are ready to hunt for bargain counters which has been trading at low book valuations. You did some basic calculation and are convinced that you are ready to part with your money on this counter. You put all your savings thinking that you are a long term investors and are paying a decent entry price to the counter.

10 years. 20 years. Your hair color has changed and you have grown slightly shorter. The company you owned since those days announced bankruptcy. Oops. All goes the nest eggs you have saved all these years. What has gone wrong?




A value trap is a concept that specify market price which looks inexpensive relative to its intrinsic value, but with hidden agenda. Because investors buy stocks on the assumption that they will one day return to their intrinsic value, they may get stuck on these stocks for a very long time or in the worst case scenario lose completely their capital.

There are many explanations for why a company can be considered a value trap. Below is what I have considered as one of them.

A good deceptive usage of book value would be manufacturing companies who hold plenty of machineries and equipment on their balance sheet. They are part of the PPE portion on the assets segments which are depreciated on a yearly basis. Depending on the treatment of the depreciation method the company is adopting, they usually result in lower book value at the end of the day since these assets are depreciated over time. Even if there is a resale value for these equipments, they usually go down faster than how they would have been depreciated, thus causing a value trap for investors who only rely on the price to book ratio to make decision. To a layman who don't understanding all of these, think property and car for example. While one can appreciate in value, one depreciates in value. The book value 10 years ago and 10 years later assuming everything else the same will not equal the same since the latter has been depreciated.

Value Play

On the other hand, a value play is something which is completely the opposite of the former.

If you are cashing in on a value play counter, you usually make a multi-bagger returns for the amount of known unknown risk profile you have taken. Sometimes it may take several years for those value to be unlocked, but you will be handsomely rewarded if you get it right.

Just like the former, there can be many different explanations and justifications for finding a great value play stocks.

One example in finding value play companies is understanding the adoption certain accounting treatment. Take the recently implemented new standards of fair value accounting for Non-Mark to Market Assets treatment for instance.

Some years ago, many assets that you see in a financial statement were valued at their historical costs. Since then, the Financial Accounting Standard Board (FASB) and International Accounting Standard Board (IASB) have been working on harmonizing such standards related to fair value accounting. Today, companies are encouraged to report their non-mark to market assets under development on fair value accounting to provide a more transparent way of disclosure. There are many companies who are already doing this and this is evident from the many one-off gains recognized in the financial statements especially from this year. Some companies may not have adopted this method of reporting yet and this may be something you can take advantage on as an investor since the known unknown is not disclosed readily to the public.

Conclusion

There are no hard rules for right or wrong investment decision based on any metrics you have. That said, having a better understanding of how a book value is derived would help you think deeper and whether the stock you see at face value fits your investment profile. Filtering is a great tool to help you save time, but they won't be your life saver when you need them.

Book value hunting is no easier than any other types of investing.
Always be safe and dig deeper.

What about you? What is your perception of the Price to Book value metrics? Any counters that meets your value play profile?

11 comments:

  1. Book value is almost irrelevant these days because we are way past Graham's time where information assymetry was common and many net-nets existed. P/B can be fundamentally flawed because book value is based on historical cost and many of the assets may have market values (or firesale values) which are very different. You need to actually adjust the book values of the assets and liabilities to find out their "current" value, and I would recommend looking at such companies on a reproduction cost basis (i.e. what a competitor would pay to reconstruct the Balance Sheet of the target company).

    One way book value IS useful is for banks. They are always valued based on P/B because the assets and liabilities are marked to market loans and securities.

    Regards.

    ReplyDelete
    Replies
    1. Hi MW

      Thanks for the discussion and thoughts on the different ways of asset valuation. I went to research regarding Greenfield and certainly lots of things to learn from it. I will share with the rest if I decide to write them for educational purpose.

      Delete
  2. Hi B,

    Personally I'm quite a fan of P/B. However, from my feeling in today's market, close to nobody except maybe REIT investors look at the P/B ratio. P/E ratios (and their variants like EV/EBITDA) are all the rage these days.

    I consider value traps to be companies with discounted P/B ratios, but with conflicting messages from other valuation metrics. Especially so if the other valuation metrics are shown to be very similar to comparable companies. To me, it means that this company is just very inefficient in using their capital. They use much more capital than competitors to generate the same outcome (earnings).

    However, if the P/B is low and other valuation metrics concur, then I sit up and get more interested to analyze it deeper if it really is a value play!

    ReplyDelete
    Replies
    1. Hi GMGH

      Yes much certainly so.

      Lesser people are viewing the P/BV because net-net assets are no longer like what we used to have in the past with only industries and manufacturing companies to compare to. These days, we've got plenty of different industries and each metric is more applicable to each, so comes a different metrics.

      Let me see if I can get it out some earnings valuation metrics out there to combine with the former. I think combined together they can be really useful to use.

      Delete
  3. Hi,

    Pls do not confuse book value with intrinsic value. Though for some companies the growth of book value are similar to its intrinsic value.

    M

    ReplyDelete
    Replies
    1. Hi M

      Definitely.

      Book value is very much flawed these days just on face value so they definitely don't represent an intrinsic value of a company.

      Take care.

      Delete
  4. Hi B, nice take on the Book Value indicator. Personally, I am relying more than one indicator in assessing the counters. Book Value is only one of them.

    Cheers!

    ReplyDelete
    Replies
    1. Hi Richard

      You practice what you say.

      I can attest to that :)

      Delete
  5. Good discussion on the Price / Book value B. Value traps are pretty hard to avoid for most bargain hunters!

    I actually like to use the P/B ratio for some businesses, just because it gets me thinking about what I'm actually getting when I buy a share - including the 'intangible' assets. I realise the values on the books might not be quite right, and you can have nasty things like impairments of assets which make those book values disappear pretty quickly if the business can't justify the values (part of my job is actually helping businesses with impairment testing, and valuing intangible assets for accounting purposes to put on their books). If you're going to put any serious weight on your decision with P/B you definitely need to think a little deeper about it, but combined with a few other filters or checklists you have it can be pretty helpful.

    Cheers,

    Jason

    ReplyDelete
    Replies
    1. Hi Jason

      You are spot on.

      P/B ratio is indeed not too relevant for some industries and you will see in the part 2 of my next post how this can be better avoided. For example, valuing intangible assets for companies like Microsoft is incredibly difficult as compared to Mcdonald and so on.

      Definitely an interesting checklist to dig deeper on once you have eyes on which industries and companies to analyze.

      Delete
  6. Hi B

    I recently read this post about book value:

    "In a world of yesterday where a companies assets were liquidated and shareholders received proceeds, book value would count. In today's world, a Judge would allow the company to be taken private, to save jobs. Common shareholders have their shares canceled. I have seen it happen over and over. So please don't site book value as a consideration for holding shares. The worst is not the company having to liquidate, as you have stated. Its "dba" (doing business as) usual privately owned with shares canceled".

    Do you know if this is true?
    And also with a takeover(hostile and friendly), that you can risk losing money, while you are waiting for the stock to appreciate in value?

    ReplyDelete

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