There is a common belief in the market that stocks that trade at less than their book values are perceived to be cheap, while stocks that trade way above their book values are deemed overpriced.
The book value of a company refers to how much the company will be worth if it liquidated its assets and paid all its liabilities. Investors have this notion that when the market value of a company has fallen below its net worth, it is deemed a bargain sale, hoping that the stock will eventually recover and revert to its book value, at the minimum.
Some investors also compare stocks by relative valuation using price-to-book (P/B) ratios. A P/B ratio is computed by dividing the share price of a stock by its book value per share. Similar to comparing price-to-earnings (P/E) ratios, stocks with lower than market average P/B ratios are considered undervalued.
The average P/B ratio in the market today is about 2.6x, but this number may be a little bit distorted since there are around 30 stocks that have an average P/B ratios of 6.0x. So, a better way to set a benchmark is to get the median P/B ratio, which is at 1.67x.
Based on this standard, there are about 60 stocks whose P/B ratios fall below the median cutoff. Moreover, there are 25 stocks within this group that are trading below their book values with an average P/B ratio of 0.65x.
While these stocks offer steep discounts to book value and market average, it doesn’t necessarily mean they are cheap. Some stocks deserve to trade at a huge discount to its book value because of poor earnings growth prospects. Other stocks may be trading at low P/B ratios because their earnings are not enough to justify the company’s internal rate of return.
In the same way, not all stocks with high P/B multiples are overvalued. Some stocks deserve to trade at a premium while others may still be undervalued despite trading at above market P/B ratios.
Every stock is unique. Though some stocks share similar characteristics, they have various fundamental differences in terms of risks and growth prospects. Hence, it is not reliable to value a stock by simply referencing the average P/B ratio in the market.
Valuing a company’s stock based on P/B ratio is best determined by its ability to create value for its shareholders. When a company earns more than its opportunity cost on their investments, the excess returns that it generates can help add value for the stock.
Moreover, the prospect of good earnings growth also means greater cash dividends in the future. A company’s willingness to pay regular cash dividends at an increasing rate sends a powerful clue about its future growth, which helps drive price-to-book ratio to increase.
To validate this argument, let’s run a simple regression model that predict the fair P/B ratio of a stock as directly determined by the company’s return on equity (ROE) and dividend payout ratio (DPO). This model will assume that an increase in any of two variables will also increase the P/B ratio.
Using the historical data of all listed stocks in the PSE, the resulting model summarized as P/B = 0.12+ 0.18ROE + 0.08DOP confirms that there is a strong positive correlation between the P/B ratio and the two determinants at 42 percent.
Using this model to predict the fair P/B ratios of stocks, we have found that around 65% of the stocks at current share prices are still undervalued.
Some of the notable stocks that are undervalued by at least 20 percent to its fair P/B ratios are First Gen(2.26x P/B), Filinvest Land (1.72x P/B), Alliance Global (1.92x P/B), Petron (2.25x P/B), Leisure and Resort World (3.11x P/B), Aboitiz Power (3.53x P/B), Cebu Air (5.27x P/B), Manila Water (2.53x P/B), Chinabank (1.96x P/B), Phoenix Petroleum (2.11x P/B), San Miguel Corp. (1.25x P/B) and BDO Leasing (2.04x P/B).
Stocks that trade at low P/B ratios are not necessarily bargains, but they can be a good starting point for value investing opportunities. The book value of a company is simply a historical cost that has nothing to do with the future. It is the expectation about the future of the company that determines the value of a stock.