A Note about Price-to-Book Value

This is the first post in a recurring series in which we explain one of Panoptic Management Consultants, Inc.'s core investment beliefs or principles.

Since Benjamin Graham, the father of value investing and author of The Intelligent Investor, price-to-book has been considered an important benchmark in determining whether a stock is selling at a discount or a premium. Benjamin Graham was famously quoted as saying, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." In other words, sometimes the market is not acting efficiently and does not accurately value equities, but over time the market will be able to reflect the true value of a company. The issue was, how does one know if the company is currently being "voted" on by the market, or being "weighed."

Graham came up with an ingeniously simple method of determining whether a stock was being sold at a discount or not. His rule of thumb was to only buy companies that were selling for 66% or less of their tangible book value. Book value is a company's net asset value and in theory is the amount of money received if a company liquidated all of its assets. Because Benjamin Graham was only buying companies worth 66% or less of their theoretical liquidation value, he thought this gave him something called a "margin of safety". He proposed that a margin of safety limited his downside and provided more opportunity for upside. His price-to-book rule made him an extraordinarily successful investor. If you need more proof of Graham's prowess, Warren Buffet has Benjamin Graham to thank for teaching him how to invest during business school at Wharton, and later hiring Buffet at his investment firm.

Today, it is no longer as simple as only purchasing stocks that are 66% of tangible book value. In fact, there are usually very few, if any, of those stocks around. However, that does not mean that book value is no longer an important indicator of when a stock is inexpensive. Multiple studies have been shown that stocks selling below their book value or at a relatively lower book value than the market have higher returns on average than the market as a whole. Two of those studies are,“Decile Portfolios of the New York Stock Exchange, 1967-1984,” by Roger Ibbotson, Finance Professor at Yale School of Management, and the 1992 study, “The Cross-Section of Expected Stock Returns” from Eugene Fama and Kenneth French, published by the Graduate School of Business, University of Chicago. After dividing up the NYSE into decile's based on stocks' price-to-book values, The Ibbotson study, found that between 1967 to 1984, the lowest price-to-book stocks had a compound annual rate of return of 14.36% while the stocks with the highest book value had a compound annual rate of return of 6.06%. Every subsequent decile with a higher price-to-book had a lower return than the lower price-to-book deciles before it (As a reminder, past results do not guarantee future performance). Fama and French's study concluded that after studying the relationship between stock performance and P/E, market cap, leverage, market beta, and price-to-book value, price-to-book value was consistently the most useful indicator at selecting outperforming stocks.

That is not to say that we recommend investors solely rely on book value to determine investments. A stock's book value may not always be accurate and can skew the calculation. A certain level of expertise may be required in order to better gauge the true value of a company's assets. As a final disclaimer, a 1997 study entitled, "New Evidence on Size and Price-to-Book Effects in Stock Returns", by Gerald R. Jensen, Robert R. Johnson and Jeffrey M. Mercer published by the CFA Institute, concludes that, "[s]pecifically, the small-firm and low price-to-book premiums are economically and statistically, significant, only in expansive monetary policy periods, and are small, and in some instances negative, in restrictive policy periods. This evidence suggests that investors should consider the Fed's policy stance when using strategies that rely on size or price-to-book ratio."

Low price-to-book can often be a powerful indicator in selecting stocks with better than average returns, but investors must make sure to perform their due diligence before investing. Using a low price-to-book measure as a screening method to narrow down potential investments can be a great first step in identifying companies you would like to own.

If all of this sounds confusing, or you do not have the time or inclination to invest for yourself, then we would recommend that readers consider investing in low fee index funds or having a professional investment advisor make investment selections for you. If you are interested in our services, you may contact us at panopticmc@gmail.com.