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Sunday, December 30, 2012
Price-to-book worth a look
Buying shares trading below book value can pay off if the firms are profitable in long run
Published on Dec 30, 2012
By Teh Hooi Ling
Last week, we showed that consistently buying the basket of stocks whose prices are lowest relative to their earnings would allow you to vastly outperform a buy-and-hold strategy for the Straits Times Index.
Price-earnings (PE) ratio, as the name suggests, measures the value of the company relative to the earnings it is generating.
Another valuation metric used by the market relates to the assets that the company has.
Let's go back to the example of the ABC coffee shop which made $50,000 profit this year. We established that paying $250,000 for the coffee shop - five times its earnings - is cheaper than paying $500,000 (10 times its earnings).
Today, we will look at the balance sheet, the financial statement which shows the assets and liabilities of ABC.
Let's say ABC has cash of $100,000 in the bank. It also has inventory (the canned drinks, beer and coffee that it has stocked up) worth another $100,000. Assume also it has paid a rental deposit of three months which came up to $100,000. Its other assets include its ice-making machine, the refrigerator, the coffee machine, tables and chairs, and so on. In total these assets have a value of $200,000.
So on the assets side, ABC has $500,000.
But not all of the $500,000 is funded by the equity of ABC's owner, Mr Tan. He has taken out a bank loan of $100,000, and he owes his suppliers $100,000.
So, taking out ABC's liabilities, the coffee shop's net assets, or book value of its equity, is $300,000.
So if you offer to pay $250,000 for ABC coffee shop, then you are offering to pay only 83per cent of its book value. That's a discount of 17 per cent. If you agree that Mr Tan has valued his assets - the refrigerator, coffee machine and so on - fairly, then you are getting a bargain if he is willing to sell the coffee shop to you at $250,000.
However, if you put in a bid of $500,000, then you are offering to pay 1.7 times above the book value, or a 70per cent premium over the book value. To offer this kind of price, you have to be very confident that the business can generate good profits from its assets.
Again, if ABC is a listed company and it has one million shares listed, then its book value per share is 30 cents ($300,000/1,000,000). If the shares are trading below 30 cents, say 25 cents, then they are trading below book value at just 0.83 times price-to-book (PTB).
That buying stocks with low PTB pays handsomely has been proven time and time again. It was first discovered in 1992, when US professors Eugene Fama and Kenneth French published a breakthrough study on the use of PTB ratio as a predictor of a company's future stock performance.
Their study showed convincingly that the lower the company's ratio of PTB value, the higher its subsequent stock performance tended to be.
"No other measures had nearly as much predictive power - not earnings growth, price/earnings, or volatility," they said, with data supporting the claim.
Does Singapore exhibit the same pattern? Well, I repeated the test I did with the PE ratios last week.
I rank all the stocks listed on the Singapore Exchange every year based on their PTB ratios. I then put them into 10 equal groups. Stocks with the lowest PTBs go into Decile1, second-lowest into Decile2 and so on. The following year, I rank the stocks again based on their PTBs at that time, and group them into 10 groups again. The process is repeated every year from 1990 until 2012.
Again, assume we started with $100,000. The first $10,000 goes into the stocks in Decile1. At the end of the first year, we liquidate that portfolio and roll over the profits to the Decile 1 stocks for the second year. Ditto for stocks in the other deciles.
The accompanying chart shows the results. The $10,000 in March30, 1990 used to invest in the baskets of stocks with the lowest PTB every year for 22 years would have grown to $355,135. That's a compounded annual return of 17.6 per cent. Money invested in the second basket, or Decile2, grew to $108,830 for a return of 11.5 per cent a year.
Remember last week, we showed that consistently buying the lowest PE stocks in Singapore turned $10,000 into $199,847 for a return of 14.6 per cent a year during the same period?
So buying low PTB stocks beats buying low PE stocks as a strategy!
But truth be told, buying low PTB stocks is a much more difficult thing to do than buying low PE stocks. Low PE stocks are profitable companies. For low PTB stocks, many times, they trade below their book values precisely because they are not making money.
But many of such stocks eventually turn around because of the phenomenon called mean reversion. Very high profit-margin companies will see their profits come down to the mean, or average levels, over time as competition enters the market. Loss-making companies will restructure or be taken over, and become profitable again.
But be warned that some of the low PTB stocks will go bankrupt. So for this strategy to work, one has to take the portfolio approach: that is, buy a basket of such stocks, and let the gains from the winners make up for those which go kaput.
But many times, profitable companies also trade below their book values. During the dot.com bubble in the late 1990s and early 2000, many of the bricks-and-mortar companies were trading at below book. Even today, many real estate developers are trading below their book values. Perhaps it will pay to take a closer look at what assets they are holding.
Buying low PTB stocks is a much more difficult thing to do than buying low PE stocks. Low PE stocks are profitable companies. For low PTB stocks, many times, they trade below their book values precisely because they are not making money.