Finding Undervalued Stocks with the Price-to-Book Ratio

 Value investing entails buying shares of unappreciated or neglected companies at attractive prices. Investment gurus such as David Dreman and Benjamin Graham believe that investors have a tendency to pay too much for companies that appear to have the best prospects at the moment and react too negatively to companies considered to have the weakest prospects. The mispricing of securities tends to be a self-correcting process that contrarian investors can use to their advantage.

How Stocks Become Undervalued

While the market is generally efficient, there are times when stocks may trade below their intrinsic value. Here are a few factors that may drag a stock’s price below its true value.

Market Momentum and Herd Mentality

Humans are emotional creatures. As such, people invest irrationally based on psychological biases rather than analysis of market fundamentals. They buy when the price of a particular stock is rising or when the value of the market as a whole appears to be rising. They don’t want to miss out on the gains that they believe others are achieving.

Likewise, when the price of a particular stock is declining or when the value of the market as a whole appears to be falling, myopic loss aversion forces most people to sell their stocks. They don’t want to lose everything, and they’re afraid of the uncertain. So instead of keeping their losses on paper and waiting for the market to change directions, they accept a certain loss by selling. Such investor behavior is so widespread that it affects the prices of individual stocks, exacerbating downward market movements.

Bubbles and Market Crashes

When market momentum and the herd mentality run to extremes, bubbles and crashes result. The early 2000s tech bubble and the mid-2000s housing bubble were fueled by dramatic levels of overinvestment that bid up the prices of tech stocks and real estate beyond what the underlying companies and properties were worth. When the unsustainable highs began to fall, investors panicked and a crash ensued, causing some stocks to be priced closer to their true values and others to fall below their true values.

Neglected Stocks

Companies might sell for less than they’re worth because they’re under the radar of “big money” investors such as mutual funds, pension funds and hedge funds. Small-cap stocks, foreign stocks, and any other stocks that aren’t in the headlines or aren’t household names sometimes offer great potential but don’t get the attention they deserve.

Overreaction to Bad News

Even good companies face setbacks such as litigation and recalls. However, just because a company experiences one negative event doesn’t mean that the company isn’t still fundamentally strong or that its stock won’t bounce back. Companies with real value can experience a significant drop in share price when something bad happens. However, investors often overreact to the magnitude of the information, opening up buying opportunities for value investors who strictly follow fundamental principles. Those who are willing to consider the company’s long-term value and ability to recover can turn these setbacks into profit opportunities.

For these and other reasons, stock prices can become depressed despite the fact that the company continues to create value for its shareholders. Such situations present profit opportunities for value investors.

Price-to-Book-Value Ratio

The valuation process does not have to be complex to be successful. Simple valuation techniques such as the price-to-book-value ratio are easy to work with and have been proven effective in numerous studies. Benjamin Graham popularized the indicator in his books “Security Analysis” and “The Intelligent Investor.” Nobel Prize winner Eugene Fama and his research partner Kenneth French use the ratio in their three- and five-factor models to describe stock returns. Professor Joseph Piotroski uses the ratio as the only valuation measure in his F-Score methodology.

The price-to-book-value (P/B) ratio is determined by dividing market price per share by book value per share. Book value is generally determined by subtracting total liabilities from total assets and then dividing by the number of shares outstanding. It represents the value of the owners’ equity based upon historical accounting decisions. If accounting truly captured the current values of the firm, then one would expect the current stock price to sell near its accounting book value. Over the history of a firm, many events occur that can distort the book value figure. For example, inflation may leave the replacement cost of capital goods within the firm far above their stated book value.

A price-to-book ratio of 1.0 suggests the current price is equal to the proportionate amount of equity in the company that a shareholder can lay claim to by owning a share of the stock. It’s an important valuation benchmark because it reveals whether or not the market is assigning a premium to a company’s net assets as consideration for the company operating as a going concern (a price-to-book ratio above 1.0) or if the market is suggesting to shareholders that they should liquidate the company (a price-to-book ratio less than 1.0). If a company can reasonably be expected to be profitable and realize free cash flow in the future, it should trade at a premium to its book value. The seemingly premium cost to purchase the shares may still represent a discount to the monetary and opportunity cost of trying to start a competitive business instead. (Opportunity cost is the return that could have been realized by choosing to allocate one’s investment dollars elsewhere.)

The Benefits of Investing in Low Price-to-Book-Value Stocks

There is strong research support indicating that low price to book value is a criterion that will enable an investor to outperform the market. Returning to Fama and French’s research, they also found that companies with high market-to-price (the inverse of price-to-book value) ratios performed better than those with low measures. For their research, Fama and French divided the NYSE universe into deciles based on price to book value and found that those companies in the 10th decile—those with the lowest price-to-book ratios—had the best average monthly returns between July 1963 and December 1990, as shown in the table below.

The stocks with the lowest price-to-book ratios, on average, returned 1.63% a month versus 0.64% for those with the highest price-to-book ratios. In annualized terms, that means the lowest price-to-book stocks outperformed the highest price-to-book stocks by roughly 12.5 percentage points, a year, between July 1963 and December 1990. That means a $100,000 investment in July of 1963 in the stocks with the lowest price-to-book ratios would have generated over $2 million more over that period than investing in the highest price-to-book stocks.

Risks of Value Investing

There are times when stocks that are beaten down unfairly can create some of the best opportunities if you have patience. However, perhaps the biggest risk of value investing is that there are times that a stock, even after a drastic fall in its price, continues to slide despite cheap valuations.

This kind of stock is what is known as a “value trap,” whereby the stock appears to be cheap because of low multiples of price-earnings (P/E), price-to-book value (P/B), or even cash flow. Investors looking for a bargain buy into such a company only to never see the stock price improve again.

Value investors try to find fundamentally strong companies that are trading at discount prices. However, there are companies with poor business prospects that deserve to trade at cheap prices. These are the stocks value investors try to avoid.

Patience Required

Value investing is best suited for investors with a longer time horizon. Just because we identify a fundamentally strong company that is currently undervalued doesn’t mean the price will turn around immediately. It may take months or even years for the market to realize that the stock is undervalued and push the share price closer to or even above the intrinsic value.

Conclusion

Value investors look for stocks where demand for them is dropping, along with their share price. Value investors get significant discounts on their purchases by questioning the wisdom of market prices. These significant discounts allow them to not only build in a margin of safety that limits their losses in case their purchases don’t work out, but to earn high percentage returns by holding onto their investments until they rise to meet or exceed their true value.