One of the most common tools in identifying potential value stocks is the price-to-book (P/B) ratio.
The P/B ratio, computed by dividing a company’s share price by its book value per share, has been widely used by value investors in evaluating whether a stock is undervalued or not.
Normally, a stock is considered cheap when its price falls significantly below its book value.
The discount of the stock, which indicates the magnitude of its prospective return, is sometimes referred to as the margin of safety.
If a stock has a large margin of safety, does it mean that it is less risky because its risk for downside is limited?
If we are going to look at the historical performance of low price-to-book stocks in the PSE (Philippine Stock Exchange) for the last five years, we can see that a big majority, about 68 percent on the average, continued to lose value over time. For example, in 2019, about 63.6 percent of the stocks in the PSE that were trading below their book values generated a negative average return of 17 percent by the end of the year.
Prior to that year, in 2018, about 67.5 percent of low price-to-book stocks also gave a negative average return of 19.7 percent. The same situation also happened in 2015 where 74 percent of the value stocks produced an average loss of 23.1 percent.
History has shown that low price-to-book stocks are likely to lose more during periods of market decline.
Stocks that trade below their book values tend to have prior weak financial performance, which result in poor growth expectations by the market. Let’s take the case of Century Properties. This stock currently has a P/B ratio of 0.35 times, which means that the stock is trading at roughly 65 percent discount to its book value. At first glance, the stock may look very cheap, but a closer look at how the market expects the company will grow in the future suggests a negative growth of 15.3 percent.
A negative growth rate means that the stock may continue to stay dormant or lose more value in the near term.
This implied growth rate is computed using the formula g = r – B/P*ROE, where r is the stock’s opportunity cost, B/P is the inverse P/B ratio of the stock and ROE is the return on equity. In this case, the stock’s r is 9.23 percent, which is derived from the 10-year Philippine bond yield plus premium while its B/P of 2.82 is multiplied against its ROE of 8.7 percent.
Following this model, we can see that for the negative growth rate to go down, market confidence in the stock must improve to enable its share price to go up, thereby lowering its B/P.
Over at the PSE, about 52 percent of stocks presently trading below their book values have poor market growth expectations.
It is true that buying value stocks can generate spectacular gains, but it can also be a very risky strategy because low P/B stocks have uncertain growth prospects.
Stocks with large discounts to book values are not necessarily the cheapest stocks in the market. Lack of growth and low profitability make value stocks less valuable. INQ
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 82nd batch of RFP program this March 2020. To register, email info@rfp.ph or text at 0917-9689774