An article published last week on this site by Rupert Hargreaves, “Joel Greenblatt on Why P/B Has Failed but P/E Still Rules,” makes the case that the price-book ratio – or P/B ratio – is no longer particularly useful as a financial in this age of widely available financial information and services-oriented economy, while the price-earnings ratio – or P/E ratio – continues to have utility. These two venerable metrics have been around since the earliest days of serious security analysis, and were mainstays of Benjamin Graham’s own strategy.
We are happy to agree with Hargreaves’ well-made thesis insofar as the P/B ratio’s usefulness has been diminished to a degree by the relative dearth of book value-based bargains and rise of companies that do not adequately reflect their true value in their booked assets. However, we would contend that the P/B ratio still retains much of its utility. That is the subject we will be tackling today.
Rumors of my death…
Hargreaves cites investment guru Joel Greenblatt (Trades, Portfolio)’s argument against P/B (and in favor of the continued usefulness of P/E):
“Low P/E hasn’t (diminished as a value metric) but low price to book (P/B) has. But low P/B really didn’t make much sense to me. I think one reason low price to book has diminished over the years is that the economy has been less asset based earned and more services industry oriented over the last 15 or 20 years. So that the companies that are trading closer to book value with a lot of assets to generate earnings are some of the worse companies to invest in. Negative results from low P/BV. That is one of the things that I am banking on. This method like the low P/E strategy won’t diminish and hasn’t diminished over the past 40 years. The strategy to buy high earnings yield (Low EV/high Ebit) companies which have high ROIC (high EBIT/Low Invested Capital) should remain robust.”
We cannot argue with his appreciation for return on invested capital – or ROIC – as an especially useful metric; it is unquestionably one of the most valuable metrics in terms of assessing the worth of a company. That is not quite so true with the P/E ratio in all cases. Indeed, in the current rarefied market, there are few truly low P/E securities at all. And the ones that are often have an underlying pathology that justifies their lagging share price multiple.
But P/E most definitely has its uses. As does P/B.
…are greatly exaggerated
The P/B ratio is far from dead, even if it is somewhat less useful. It is true that it is no longer like Graham’s day, in which it was possible to find an array of excellent companies trading below their liquidation values. However, it is still possible to identify such companies – especially when it involves a special situation scenario. An example of that is Micron (MU, Financial). It is now trading around $50 a share. It was at that level a couple years ago as well. But in the interval, it made a full circle down below $10 only to come roaring back up. Why did that happen? Because the cyclical nature of the business and fear of microchip oversupply sent the market into a panic.
Taking a more general view, the health of the stock market and the rise of tech companies and service-oriented business has shifted focus from book values, or sometimes rendered it moot to a degree. Yet its utility remains unquestionable when it comes to a large class of stocks that still produce tangible products or operate tangible property and assets. Book value is alive and well when it comes to those businesses.
Useful in a pinch
The P/B ratio really comes into its own during down markets and recessions.
Market panic, and subsequent psychological malaise, puts pressure on all securities. Many of these get beaten down far more harshly than the broader market and without reason. In those scenarios, a P/B screener can become a powerful tool for picking up asset-rich securities at bargain prices.
The venerable ratio may have been more useful in an era of greater information asymmetry and industrials-dominated securities markets, but it is still a great tool to have in the back pocket.
P/B helped make Graham rich. It can do the same for this generation of investors, too, provided they are patient and willing to sift through the junk for real value.
Disclosure: I/We own no stocks discussed in this article.
