Why Price To Book Value Is A Good Starting Point

The use of price to book value is one of the most important and controversial subjects in all of security analysis.  Let’s begin the discussion of why we consider P/B an important variable.

  1. The academic studies have concluded it is among the most powerful predictors of future returns   Please see What Has Worked In Investing.  I was always suspicious of the studies that showed low P/E was a good predictor. Many of these stocks were cyclicals at the peak of their cycle.  A footnote in one low P/E study showed the curious result that companies with negative earnings did even better than low P/E stocks.  I was not surprised when the Fama/French work in the mid-1990’s show that P/B was a better measure.
  2. P/B works best with companies with negative or volatile earnings.  A good value investor should relish working with these types of companies. They are often widely misunderstood.  Here P/B must be used in conjunction with other metrics.  But as a starting point P/B is best.
  3. We have found there is a strong negative correlation between low P/B and Wall Street’s opinion on a stock. Pick any list of low P/B stocks and see how many you find on Wall Street recommended lists. It will not be many.
  4. With all the new rules about writing down goodwill to its economic value, P/B is even a more accurate measure that it has been in the past.

Of course, P/B is often misused.

  1. For some industries P/B makes little sense. No one in their right mind would look at a biotech firm based on book value.
  2. For firms in rapidly declining industries book value can be overstated and useless.  Polaroid was a low P/B stock for many years and then disappeared.
  3. Financial leverage can often make P/B of little value.  We watched the Texas bank stocks fall from 2x book, to book, to ½ of book, then to ¼ of book and then disappear in a massive bailout.
  4. Too many inexperienced analyst think that book value is a magic floor that a stock can never fall below. As experienced value investors we know that some stocks selling below book never recover.

But if you point a gun at our heads (please don’t), and ask where to start looking for the best idea in an industry or group of stocks, our experience teaches us the start with low P/B.

Print Friendly
About Gregg Jahnke