• Beating the market is tough, but finding quality stocks is even harder
  • Book value is a metric often used by value investors
  • We look at how the Price to Book Value ratio could uncover undervalued stocks

 

Investors are always on the lookout for strategies to outperform the market, yet the reality is that such shortcuts are often elusive.

Beating the market is notoriously challenging, and identifying high-quality stocks is even more so.

But in the quest for reliable methods to gauge a company’s real worth, one fundamental metric has stood out over the years: book value.

Many investors have been drawn to this metric due to its simplicity and the success stories of value investors like Warren Buffett, who famously amassed significant wealth in his early days by buying stocks that traded below their book value.

So what exactly is book value and how can today’s investors leverage it for success?

 

Book value defined

Book value is essentially a company’s equity value as reported in its financial statements.

It represents the total value of a company’s assets minus its liabilities.

So, at its most basic level, book value is the total value shareholders would theoretically receive if a company were liquidated, without taking into account the current share price.

Calculating book value is pretty simple:

 

Book value = total assets minus total liabilities

 

Total assets include both physical things like property and equipment, and intangible ones such as patents, trademarks, and goodwill. Note that items like depreciation is often factored in to align it with the actual value of the business.

Total liabilities, on the other hand, are the financial obligations that a company owes to external parties.

They comprise current liabilities, like accounts payable and accrued expenses, as well as long-term liabilities such as bonds payable and debt that extends over a longer period.

 

Introducing the price-to-book ratio

While book value serves as a helpful tool, it does not tell you anything about whether a stock is over or underpriced.

A more accurate approach, therefore, is to consider both the book value and how it compares with the current market value of the company.

The price-to-book ratio (P/B ratio) is the crucial metric that’s used for this purpose.

Value investors like Buffett have used the P/B Ratio extensively to assess whether a stock is fairly valued.

 

Price-to-book ratio = current share price / book value per share

Or simply:

Price-to-book ratio = market cap / book value

 

But before analysing a company’s P/B ratio, investors should consider one key factor: the current share price actually reflects the market perception of a company’s equity value in the future, not present.

Stock price is considered forward-looking because it reflects investors’ expectations about a company’s future earnings and cashflows.

In contrast, the book value is based on historical costs and may not accurately represent their current market worth of the company’s assets and liabilities.

 

A “good” P/B Ratio

When the P/B ratio is above 1, it suggests that investors are currently willing to pay more for the company’s assets than what they are currently valued on the balance sheet.

Conversely, when the P/B ratio is below 1, it suggests that investors can buy the company’s assets for less than what they are valued on the balance sheet, providing a margin of safety.

As a rule of thumb, value investors view a price-to-book (P/B) ratio below 1 as a sign of an undervalued stock.

On the other hand, while a high P/B ratio may indicate that a stock is overvalued, it could also indicate that investors are willing to pay a premium for the company’s assets. This might be because they believe in the company’s growth prospects. So a high P/B ratio is not necessarily a bad thing.

Different industries have varying P/B ratios. For example, tech or biotech stocks may have higher P/B ratios due to the value of their intellectual property and growth potential.

A note from the American Association of Individual Investors gave this general advice:

“If you’re trying to decide what a good price-to-book ratio is, you can think of this rule of thumb: Look for a price-to-book ratio of 2 or lower, though 1.25 or lower is even better.

“A well-managed company trading at a significant premium to book value (price-to-book ratio of greater than 4) should be watched but is only suitable for speculative trading until the valuation becomes reasonable.

“A company that is not well managed should never be purchased for any reason.”

 

Some ASX small caps with P/B Ratio of less than 1

Here’s a list of ASX small caps of less than 1.  This list is by no means comprehensive.

Source: Commsec

 

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