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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Thursday, September 20, 2007

Understanding the Drivers of the Price to Book Multiple

Price to book ratios are a popular method for gauging a stocks relative value. Just like price to earnings ratios, P/B multiples that are relatively high usually signify that the stock is overvalued. Investing in low P/B companies has forever been a staple strategy among value investors. Yet, stocks trading at higher P/B ratios can still be good investments and actually be undervalued.

Understanding the drivers of the P/B ratio helps determine whether the stock deserves a high multiple. Often, the P/B multiples published are not forward looking. The share price is forward looking, yet the book value (denominator) is a historical figure taken from the balance sheet.

This shortcoming results in P/B multiples failing to capture the full picture. Trailing P/E (historical) ratios exhibit exactly the same symptom therefore forward P/Es are more meaningful and popular. Thus, determining a forward P/B multiple is essential for assessing a stock’s fair value.

Lloyd Sakazaki recently wrote about P/B multiples recently in this article. Lloyd has a very informative blog which I recommend checking out. Lloyd’s primary point is that high P/B multiples may stem from high expected earnings growth.

Essentially, the future is expected to be better than the past, thus investors have bid prices higher given that expectation. Additionally, relatively high P/B multiples may be justified if the firm produces high returns on equity (ROE). Expanding on Lloyd’s commentary, we can illuminate the underlying factors affecting P/B ratios .

1) Return on Equity: ROE= EPS/BVPS

Stocks with higher ROE should trade at higher P/B multiples. Now, that’s expected future ROE, not historical. Often, a link may exist between a firm’s historical ROE and future ROE. Companies with stable performance (predictable), the past may be an indicator of the future, and what has happened usually continues to happen. Sometimes. Analyzing historical ROE trends can help in making sense of a P/B ratio. Yet, stock prices reflect future expectations; undoubtedly, it is only future returns on equity that affect share value.

ROE projections are vital to the evaluation process of P/B multiples. Future ROE estimations can be accomplished by estimating future EPS and future BVPS: Expected ROE= EPS (expected) / BVPS (expected).

To figure out next year’s BVPS, dividends and share buy-backs need to be subtracted from EPS and then added to beginning BVPS.

Expected BV/Share= BV/share (last fiscal year) + (EPS (current yr estimate) – DPS (expected dividend) - Share Repurchases/share)

Comparing expected ROE to last year’s ROE aids in analyzing the P/B multiple. If future ROE is expected to be much higher than historical returns, a relatively high P/B may be reasonable especially given the forward P/B will be much lower due to the ROE increasing.

Higher ROE translates into higher P/B multiples assigned by the market. P/B ratios have to be evaluated in the context of ROE, and since stock prices are forward looking, forward P/B multiples must be compared to expected ROE. To ascertain the appropriate P/B ratio warranted for any given ROE rate, peer comparisons are needed.

2) Expanded ROE (Dupont Formula) = Profit Margin x Asset Utilization x Leverage

Margins, asset efficiency, and capital structure determine ROE. Analyzing these underlying factors give insight in estimating future ROEs.

Net Margin (Income/Sales) x Asset Utilization (Sales/Total Assets) equals return on assets, or ROA. Multiplying ROA by the ratio of Assets/Equity (leverage) gives ROE.

a) How attractive income stream? (profit margin)
b) Amount of capital investment (Assets) required to capture income stream?
c) Shareholders’ investment required to finance total assets?

Investors’ willingly pay premiums for firms possessing highly profitable business models. The distinguishing variable is asset turnover. High profitability may require large sums of assets, hence greater investment offsets the benefit of greater return on sales. Contrarily, low margin businesses can boost returns if asset requirements are small.

Thus, firms having high margins and low asset investment needs are the most attractive and command higher P/B multiples. Finally, using debt will boost ROE since additional capital can be employed without diluting the ownership base. The use of excessive leverage compresses P/B ratios because of the increased financial risk weighs down share prices.

Companies can generate high ROE from intangible assets not recorded on the balance sheet. This will cause greater asset turnover since recorded assets are lower.

Intangible assets such as brands, technology, human capital, knowledge etc. have value since they drive earnings. Investors will pay accordingly for ownership of these intangible assets. Paying a premium results in a higher share price, and coupled with a lower BVPS due to non-recorded assts, P/B ratio is higher.
I discussed this aspect in more detail in a previous

3) Expected Earnings Growth:

EPS growth rate will affect future ROE since EPS is the numerator in the ROE formula.

P/B ratios are most often calculated by dividing the share price by the book value per share. The BV/share is the amount of shareholder’s equity found on the balance sheet (assets-liabilities=equity) divided by the number of common shares outstanding.

Since stock prices reflect future expectations, a P/B multiple calculated from a historical book value leads to distorted ratios. We can calculated a forward looking P/B multiple that will make comparisons more meaningful.

Forward P/B Ratio= Current Price / Expected Book Value Per Share

If expected earnings causes a significant increase in future book value per share, then there will a considerable difference between trailing P/B and forward P/B ratios. This is especially true is EPS has been negative causing BVPS to decline. Hence, P/B ratios may be distorted if BVPS is depressed, yet estimating a forward P/B ratio will reveal if the P/B is still relatively high.


To better gauge if a P/B ratio is warranted, earnings and ROE expectations need to be examined. P/B ratios may be high on a trailing basis, but considerably lower on a forward basis. After uncovering the firm’s prospects, peers should be referenced for comparison. If P/B is relatively high and ROE is much higher than comps, then the higher multiple may be warranted. A common mistake is thinking a stock is undervalued because of a low P/B. If ROE and EPS growth are below average, then that’s the reason why the multiple is below average. It’s not undervalued; it deserves a low multiple because it’s expected to deliver low returns. Share prices indicate the future expectations of ROE as indicated by the P/B multiple. High multiples are justified when the ROE expectations implied are reasonable, and even higher multiple is warranted if you believe the implied ROE is too low.


Clovis said...

I heard my friend said that, some of the property stocks' P/B value is very high due to the land purchase price is very very low, like some China property company bought the land from farmers. is it true?

Turley M Muller said...

Yes that can be true- Land is recorded on the balance sheet at historical cost, the price it was bought at.

Other Assets, such as buildings, factories, machines, equipment etc. depreciate because they don't last forever. But real estate does not depreciate in the sense of use. It just loses value or gains value based on demand. Yet, only when it is sold and taken off the books is the value adjusted. So, a firm could own property in bought on the cheap that has become very valuable if they were to sell, but that is not reflected on the balance sheet. Since real estate most always appreciates in the long-run, old properties are certainly understated in value.

Lambert realized that when he bought K-mart out of bankruptcy, he knew that the land was worth much more than the book value, so he was able to acquire and sell it for a big gain and pay down some debt used to buy k-mart company.

I am sure that in China, much land was bought from farmers at a low price compared to what it's worth years later.

Hidden / intangible assets not on balance sheet can result in a higher P/B if the market recognizes the value.

DG said...

Excellent article, this blog is great always relevant postings. Congratulations! I'm from Brazil and also do operations on the financeiro

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