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.

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