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Are stocks at historically low book values?

Dec 22, 2008

Every company needs funds to run its business. It uses these funds to buy assets. Assets like machinery, buildings, furniture, inventory etc. It uses these assets to make products or offer services and sells these at a price above its costs to earn a profit. The funds the company uses to buy such assets can come from two sources - debt or equity. Debt is the borrowed money on which the company has to pay fixed interest. Equity on the other hand is the money put in by the owners.

Equity is also referred to as 'book value' (BV). The BV of a company can be calculated by subtracting the debt from the value of the total assets of the company. What remains is the value of the assets owned by the shareholders of the company. When you buy a share in a company, it is this underlying asset that you own.

When times are good, inflation rates and interest rates are low, people are willing to pay a premium for owning equity in the companies. During these times, the rates that an investor can achieve from risk free instruments like government bonds are much lower than the average return on equity a good business earns.

The Price to Book ratio (P/B) is a measure of how attractive investors find owning such companies. It is calculated by dividing the price per share by the book value per share. If you buy a share at the price of Rs 500, and its BV per share is Rs 100, then you are willing to pay 5 times the value of the equity in that business.

P/B values over the years
Historically, when times are good and corporate earnings are rising, investors become more and more willing to pay a higher price for equity. Conversely, when they are worried about the external climate or get spooked by some negative events, they suddenly become less willing to pay that much for the same equity stake.

The chart tracks the historical aggregate P/B for stocks in the NSE Nifty as a whole that investors have been willing to pay since 1999:

Source: National Stock Exchange

The investors' enthusiasm for stocks wax and wane with the macro economic climate changes over time. By buying in an unfavorable environment, the investor gets to enter into businesses at a much lower price that eventually yields a better return than buying the same thing at a higher price.

Over time, as the investing community's pessimism turns to optimism again and the investor who had bought into the good business at a low price gets a double benefit. One, the book value of the stock continues to increase as the business earns and retains its profits over that period. Second, a rising appraisal of that equity ownership will ensure that the investor will be able to command much better prices at which he can sell the his stake. That is the reason why it makes so much sense to buy at the current juncture when price to book values are close to the their historical lows.


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