Is the Famous Price to Book Value Ratio Headed to Graveyard?

Jim O'Shaughnessy, a famous investor in the west and who has written a bestselling investing book 'What Works on Wall Street', argued in a recent interview that the famous valuation metric of 'Price to Book Value' is all but dead.

Here's Jim...

• Specifically, to that factor [price to book], I would advocate investors don't really look at it anymore.
  
  And that is based not on my opinion, but on very deep research that we did. We published several papers about it, we had a podcast about it, and it has to do with the changing nature of valuing businesses.
  
  Price to book was great for industrial type companies, and typically price to book, a low price to book, was very good going forward. A high price to book meant probably overpriced.

The business landscape has changed as per Jim. And this new business landscape demands that a new valuation metric be used and an old one like price to book value be discarded.

Well, I use price to book value extensively in both my services i.e. Microcap Millionaires and Exponential Profits.

In fact, it is one of the most important valuation ratios for us and had a huge role to play in our strike rate of close to 80% across both the services.

Therefore, does Jim's big statement throw cold water on our plans of using this ratio going forward? Should we also discard it in favour of something new and something that works better?

Well, not so fast. To arrive at a proper conclusion, we will have to go deeper.

We will have to figure out Jim's main reasons for discarding the ratio and whether they really make sense, especially in the Indian context. Let's find out.

Jim's top reason for dropping the price to book value ratio was the changed business landscape.

Jim is of the view that price to book is great for industrial companies. Now, these are companies that own a lot of hard assets like plant and machinery, inventory, land, etc.

In other words, price to book makes sense for companies that own a lot of tangible assets. However, the stock market these days is dominated by companies that own a lot of intangible assets. Think of stocks like Apple, Nike, Amazon, etc.

A lot of the market value for these stocks is determined by the power of their brands and the power of their networks.

As these do not reside on the balance sheets, using price to book to value these companies is not correct. We need other valuation metrics.

Now, I agree with Jim that the presence of a lot of intangibles across companies, makes price to book value the wrong valuation tool with which to value them.

However, we still need industrial companies and a lot of these still exist in India. I don't think stocks from the metal, paper, textiles, auto, auto ancillaries, real estate, cement, etc have a lot of intangibles on their balance sheet.

These are companies where the tangible assets form a bulk of the assets on the balance sheet. Hence, book value for such stocks becomes an important number to track.

And these are exactly the kind of stocks that we have recommended in both Microcap Millionaires and Exponential Profits.

Therefore, till the time such stocks exist in large numbers in the country, price to book value is not likely to go out of fashion. It can co-exist with other valuation ratios like PE, price to cash flow, EV/EBITDA etc.

The second issue Jim had with price to book value is that the ratio did not work when it was needed the most.

Jim made a reference to the crash of 1929 and the depression that followed and argued how the lowest price to book value stocks were actually the ones that suffered the biggest fall and the ones with the highest price to book ended up doing much, much better.

Well, this could be true. However, Jim has not mentioned anything about the underlying business quality of the low price to book stocks.

Was it good, bad, ugly? Without this information, it is hard to come to any definite conclusion about the usefulness of the price to book value ratio.

You see, when it comes to Exponential Profits or Microcap Millionaires, we are not just about stocks with low price to book value or low price to earnings. We are also about the underlying business quality.

For us to recommend a stock, the stock should not only be trading at a discount to its book value or at an attractive PE multiple, but it should also be a business that's at least of average quality if not the best.

By average, we mean a balance sheet with a limited amount of debt and an earnings track record going back a few years.

We are fine if the company is not zero debt and does not have bright growth prospects.

However, the debt on its balance sheet should never exceed equity. Plus, it should not be a loss-making operation.

A highly leveraged penny stock with a loss-making operation is a value trap according to us and we may never recommend it no matter how attractive the valuations. We try to zero in on only the best penny stocks in India.

Therefore, taking into account both the low price to book value as well as the underlying business quality ensures that the company has a better chance of being a successful investment than a value trap.

Thus, it is for these two reasons i.e. the presence of large number of industrial companies and a detailed inspection of the underlying quality of the business, we believe that investing based on price to book value does make sense, at least in India.

We would therefore continue to deploy the ratio in the future as well. I strongly believe even you should do the same.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter

PS: Speaking of ratios, here's another important one that has enabled a portfolio of small cap stocks to go up an impressive 800% in just a decade. Check out this video to find out all about this ratio.