For years, analysts have been using the price-to-book ratio (PBV) to differentiate stocks into growth and value categories. The ratio which is simply the market price of a company’s stock divided by the book value of equity per share has remarkable characteristics in being able to ferret out value. Here’s why.
The Market value of a firm is the market’s expectation of that firm’s earning power and cash flows health. The book value is the value found on the balance sheet of the company. Since both the market value and the book value of firms are readily available–and at least somewhat consistent in measurement– the PBV ratio is simple but powerful tool in stock selection.
Underlying the simplicity of the PBV ratio are the twin disciplines of economics and finance, which combine to produce valuation metrics. The financial rigor expended in finding the fair value of a share is embedded in the price of the companies stock. In fact, if we take the simple constant growth construct for finding the theoretical value of a stock and substitute in the estimates for growth and the cost of equity, we find that the PBV ratio is a function of three basic components–the Return on Equity (ROE), the Cost of Equity (COE) and the growth of dividends per share (g).
As a result, research tends to focus on discriminating among shares based on the PBV and the equity return spread (ROE – COE). High PBV ratios can be divided into two sets. Those with high equity return spreads conscribe to the risk / return doctrine, while those with low equity return spreads are classified as overvalued, or growth stocks. As for the stocks that have low PBVs, those that have low equity return spreads are again consistent with the risk / return doctrine, while those that exhibit high equity return spreads are considered to be undervalued, or value stocks.
The classification can be achieved via a matrix approach, like the one described above, or through use of regression techniques. The simplest regression model would be as follows : PBV = a + b.ROE. In this example, value stocks would lie below the regression line, while growth stocks would lie above the regression line.
The PBV ratio is one of those rare simple ratios, like the price earnings ratio, which has a great deal of explanatory power. Three clear advantages of the price book ratio over the price earnings ratio are that the PBV is more stable, less susceptible to creative accounting and is not susceptible to negative earnings growth in certain quarters, as is the PE ratio. Subsequent articles will look into the PBV ratio in more detail, including measurement errors and normalization techniques used by investment professionals.