Hot Money Monday: Why value investors like to use this metric to uncover undervalued stocks

• Beating the market is difficult, but finding quality stocks is even harder
• Book value is a metric often used by value investors
• We examine how the price-to-book ratio could uncover undervalued stocks

Investors are always looking for strategies that can help them outperform the market, but the reality is that such shortcuts are often hard to find.

Beating the market is notoriously challenging, and identifying high-quality stocks is an even bigger challenge.

But in the search for reliable methods to measure the true value of a company, one fundamental yardstick has stood out for years: Book value.

Many investors are drawn to this metric because of the simplicity of this metric and the success stories of value investors like Warren Buffett. Buffett famously amassed significant wealth in his early years by buying stocks that were trading below their book value.

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

Book value defined

The book value is essentially the equity value of a company as reported in its annual financial statements.

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

Book value is basically the total value that shareholders would theoretically receive in the event of a company being liquidated, without taking into account the current share price.

Calculating the book value is quite simple:

Book value = total assets minus total liabilities

Total assets include both tangible items such as property and equipment and intangible items such as patents, trademarks and goodwill. Note that items such as depreciation are often included to bring them into line with the true value of the business.

Total liabilities, on the other hand, refer to a company’s financial obligations to third parties.

They include both short-term liabilities, such as accounts payable and accrued expenses, and long-term liabilities, such as bonds and debts that extend over a longer period of time.

Introduction of the price-to-book ratio

Although book value is a useful tool, it does not provide any information about whether a stock is overvalued or undervalued.

A more accurate approach is therefore to consider both the book value and its comparison with the current market value of the company.

The Price-to-book ratio (P/B ratio) is the key metric used for this purpose.

Value investors like Buffett use 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 capitalization / book value

But before analyzing a company’s P/E ratio, investors should consider one important factor: the current stock price reflects the market’s perception of a company’s equity value in the future, not the present.

The share price is considered forward-looking because it reflects investors’ expectations about a company’s future earnings and cash flows.

In contrast, book value is based on acquisition cost and may not accurately reflect the current market value of the company’s assets and liabilities.

A “good” P/B ratio

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

Conversely, a P/B ratio below 1 means that investors can buy the company’s assets cheaper than they are valued on the balance sheet, thus having a margin of safety.

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

On the other hand, while a high P/B ratio can be an indication that a stock is overvalued, it could also be an indication that investors are willing to pay a premium for the company’s assets. This could 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 different P/B ratios. For example, technology or biotechnology 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:

“When 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 less, although 1.25 or less is even better.

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

“A company that is not well managed should never be bought.”

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

Here is a list of ASX small caps with less than 1. This list is by no means exhaustive.

Source: Commsec

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