Why Price To Book Is So Important

August 29, 2017

Why Price To Book Is So Important

  • The stock market has been only going up in the last 8 years, and will probably continue to do so.
  • Nevertheless, it’s good to take a look at valuations and other financial metrics.
  • One metric that’s often disregarded but extremely important is price to book value.

Introduction

The stock market (S&P 500) didn’t go higher last month, which is, to be a bit sarcastic, very strange.


Figure 1: S&P 500 from July 24 to August 24. Source: Yahoo Finance.



Nevertheless, this is just a minor pause on what has been an extraordinary bull market in the last 8 years.


Figure 2: S&P 500 in the last 5 years. Source: Yahoo Finance.

However, there have been periods, like in 2015, where stocks were flat or a bit down for a while. Nobody knows where stocks will go next, but there is a high probability that they will continue to climb as there are many positive factors influencing stock prices.

I always like to look at stock market valuations just to see how they fare as they are what determines your long-term returns.


Figure 3: S&P 500 PE ratio. Source: Multpl.

The current PE ratio of 24.36 means that long term returns from the current S&P 500 will be around 4% which isn’t that good, especially when compared to the past.

Since 1881, the average PE ratio has been 15.66, thus we are now 55% above the historical average. The lowest point was in 1920 when the PE ratio was 5. So, just before the best decade for stocks, people were pessimistic about stocks.

It’s interesting how the best time to buy stocks is when nobody wants them while the worst time is when everybody talks about stocks, thus right now. Optimism and pessimism are good investing indicators. If you do the opposite, you’ll do fine.

The cyclically adjusted price earnings ratio (CAPE) is even higher than the PE ratio.


Figure 4: The CAPE ratio is above the 1929 level. Source: Multpl.

As with the PE ratio, the CAPE ratio was the lowest in 1933, 1982, and 2009, all amazing periods to invest in stocks.

A look at global CAPE ratios shows that Russia and China are still the cheapest.


Figure 5: Global CAPE ratios. Source: StarCapital.

However, be careful as in China, the largest companies are banks, and I’ve described the risks to Chinese baking here, and for Russia, most companies depend on oil prices. Despite those issues, I still think it’s much easier to find a good investment in Russia or China than in the U.S.

In Europe, the investing risk is much higher than in the U.S. while the CAPE ratios aren’t much better. Germany has a CAPE ratio of 20.5, while France has 19.5. As was the case with China, only individual, well thought out investments make sense.

Price To Book Ratios

I want to conclude this article with something that isn’t often discussed but in my opinion, is extremely important.

I believe that price to book ratios are an amazing metric for lowering investing risk and increasing returns. It isn’t just me, it has also been scientifically proven that value stocks, those with lower price to book values, have significantly better returns than growth stocks by Nobel prize winners Fama and French.

A look at the S&P 500 price to book value will show that we are currently far from value and deep into growth territory.


Figure 6: S&P 500 price to book ratio. Source: Multpl.

Book value is something you can hang your hat on when you invest. However, paying 3.2 times more than the actual book value of an investment makes investing very risky.

So let’s say there’s a recession. Stocks are marginal businesses and just a small change in revenue can easily bring the margins to zero or turn them negative. This would eliminate earnings. Now, tell me if you you would still pay 3.18 times book value for a company that has no earnings? I know I wouldn’t.

That’s my biggest concern in this market, not so much the PE ratios. PE ratios are always temporary and variable.

Further, companies are doing huge buybacks. However, if the S&P 500 PE ratio is 24, it means that S&P 500 earnings are exactly 100. As the price to book ratio is 3.18, it means that the book value of the S&P 500 is 768. Further, this means that the return on equity for S&P 500 companies is a staggering 13%.



My question is, why would you buy your own stocks where the return is 4% and pay 3 times book value, when you can invest in your business and get a 13% return?

The reason is that buybacks push your stock prices up immediately, while investing in business takes a while to get traction and show positive signs. It’s funny how even investors prefer buybacks  and growth in place of investments in the long term. The sad thing is that such an attitude will sooner or later end badly.

Conclusion

I’ll conclude with a request. Please check whether what you own in your portfolio is aligned with your investing goals. If your goal is to retire in 20 years and the management of a company you own is doing buybacks at three times book value, then they are maximizing the value of those who are selling to them now. They are not maximizing your 20-years-from-now value.

Be sure to own stocks where the management has your best interests in the first place, or where at least your interests are aligned with the managements’. For example, there are companies owned by families where the only goal is to grow the business indefinitely.