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 article.

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.

Summary:

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.

High P/B Multiples do not Preclude the Notion of "Value"

Low price/book ratios have always been a primary tool to the value investor. Ben Graham popularized the ratio with his version of “net-net” stocks which were companies trading for less than net liquid assets. In today’s markets, those particular opportunities rarely, if ever present themselves.

Buying low price/book stocks has research to support its effectiveness. Fama and French conducted a study which found stocks in the bottom deciles for price to book ratio, outperformed stocks in the top deciles, as well as the market in general. An opposing argument states the reason for outperformance was due to added risk that was inherent in stocks with such low price/book ratios.

The underlying rationale is that these stocks have an uncertain future, thus investors react by taking the stock price down (boosting P/B ratio) to a level that is commensurate with the higher level of risk. Investors hailing from the Value discipline, argue that there is less actual risk since lower stock prices provide higher margins of safety. Market prices are now closer to book values, which to some degree, represent a value achievable through liquidation, at minimum. Either way, all these arguments appear to contain some logic.

So, is investing in stocks with low price/book ratios superior? * Low absolute price/book ratios- most likely NO. * Low relative price/book ratios- most likely YES. So what are the implications to those two statements? High price/book ratios don’t automatically imply a stock is overvalued and vice-versa.

It is my belief that high price/book ratio stocks should not be eliminated from an investor’s universe of potential buy candidates in spite of a high P/B ratio alone. Actually, I believe that companies with high P/B ratios can be great investments.

In cases where a company is “asset light”, value can be created from core competencies that arise from intangible assets, rather than from hard assets that are recorded on the balance sheet. “Asset light” firms do not require large sums of capital to invest in physical assets such as property, plant, equipment, and large inventory stocks. Asset intense firms will have lower returns on capital because of the large capital base needed to generate those returns. Moreover, growth is less valuable to the investor since large infusions of capital will be needed to increase and support higher returns. Yet, companies that require little capital assets do not need large amounts of cash to operate and grow. Less cash needed equals higher free cash flow which ultimately means higher market value.

Since Asset light companies possess assets not recorded on the balance sheet they will sport higher P/B ratios. Intangibles such as distribution networks, brand equity, expert knowledge, and an efficient organizational structure/business model, are all assets not listed in the financials. Yet, all those aforementioned factors contribute to a firms competitive advantage and its sustainability. These intangibles, or “x-factors”, allow a business to earn large returns on a small capital base. Firm strategy and the competence of management largely determine the returns to invested capital, not the actual physical capital itself.

A prime example of an “asset light” firm is Dell. Its stock provided monumental returns to investors in last decade. Dell had little physical asset needs since it had no retail stores, outsourced most product manufacturing, and possessed the ability to keep low inventory levels. Dell benefited from “x-factors” such as its distribution network and direct business model. Through the efficient and pragmatic organization of physical assets, Dell could operate with a fraction of capital than what its competitors required due to inferior strategic operating models.

Apple is another example. Its firm knowledge and brand equity allow Apple to generate higher returns than its peers with the same level of physical assets. Therefore, it makes perfect sense that Apple should trade at a higher multiple to book value.

Firms that require little capital to generate returns are attractive. Firms that possess “x-factors” that boost returns are even more attractive. These firms will have lower recorded balance sheet asset values than industry or sector averages, thus (all else equal) absolute price/book ratios will be higher than average. Firms with low absolute price/book values imply that more capital is required to generate adequate returns for investors. Thus, fewer “x-factors” are involved.

My goal is to demonstrate that stocks with high absolute P/B ratios are not necessarily overvalued. Further, it is likely that those members are above average businesses. What is important is to discover what the appropriate P/B ratio should be, for all stocks. The best way to accomplish this is on a relative comparison basis. After research and analysis is complete, an investor can then decide if a stock with a very low absolute P/B multiple is overvalued or if a stock with a very high absolute P/B ratio is undervalued.