Finding bargain stocks with price-to-book ratios

In times like this, when the economy is going down, it is not unusual to see many losing companies end up trading with negative price-to-earnings (PE) ratios this year.

When this happens, it is best to look for other pricing multiples to get meaningful comparisons of stocks. One of these is the use of price-to-book value (PBV) ratio.

The PBV ratio—computed by dividing the share price of a company by its book value per share—indicates how much investors are willing to pay for the net assets of the company.

For many years, the PBV ratio has been associated with value investing. There is a common notion that when a stock trades below its book value, it is considered a bargain.

For example, Alliance Global has a PBV ratio of 0.38 times. To a value investor, this stock has the potential to double its share price in the future because it offers 62 percent discount to its book value.

The recent fall in the stock market has also increased the opportunity to buy value stocks. The number of stocks in the Philippine Stock Exchange (PSE) that trade below their book values has significantly risen to 53.2 percent from to 41.2 percent last year. Three years ago, when the market was still strong, this was only 35 percent.But like the PE ratio, a stock with low PBV ratio does not always indicate that it is undervalued. Conversely, a stock with high PBV ratio does not necessarily mean it is overvalued.

The book value of a stock, which is the difference between a company’s total assets and total liabilities, does not reflect the earnings power of its assets. And because of this, it cannot proxy as intrinsic value.

A company can have large book value of fixed assets but if its earnings are not enough to justify its investments, it will have a lower intrinsic value.

The PBV ratio of a company relies on its ability to generate return on equity (ROE) higher than its cost of equity (COE). The larger the differential returns, the higher the PBV ratio of the stock. For example, Globe Telecom may look expensive at PBV ratio of 3.43, but if we look at its trailing ROE, the stock has a 26.2-percent return against its COE of only 5.9 percent. The huge net returns will tell us that the stock’s premium is justified.

On the other hand, a stock like Cemex Holdings may look cheap at PBV ratio of 0.37 but its negative returns of 0.8 percent from its low trailing ROE of 2.8 percent against COE of 3.7 percent will show that the stock is fairly valued.

Because every stock has different risk and growth profile, we cannot just value a stock by simply comparing its PBV ratio with others.

To estimate the intrinsic PBV ratio of a stock, we must first get the difference between its ROE and expected growth rate then divide it by a discounting factor represented by its COE minus the same growth rate. Let’s take the case of Puregold, which is currently trading at PBV ratio of 1.49. This stock has a 12-month ROE of 11 percent and COE of 5.4 percent.

If we assume a long-term growth of only 3 percent, by following the model above, we can estimate the stock’s target PBV ratio at 3.38 times. At this ratio, the stock is undervalued by 55 percent.

Over at the PSE, the median PBV ratio of the market is 1.47. Given the market ROE of 10.7 percent and COE of 7.9 percent, if we assume the same growth of only 3 percent, we can estimate the market’s PBV target at 1.60. At this target PBV ratio, the PSE index may be good for another upside of at least 9 percent. However, once earnings are out in the next quarters, the trailing ROE of the market may fall significantly, which will lower its PBV.

The relationship between the market price of a stock and its book value is much more complicated than we realize. It is not the comparisons that make a stock cheap or expensive, but it’s the value that it creates in the long term. INQ