Most if not all value investors will be aware of the price-book (P/B) ratio. The ratio was virtually invented by the godfather of value investing Benjamin Graham and formed an essential part of his investment criteria. Buying a stock that is trading significantly below its P/B figure was to Graham the holy grail of investing with minimal risk and almost guaranteed profits.
However, the investment world has changed significantly since Graham’s time and while investing on the P/B ratio still has its merits, the strategy can lead you into some tricky situations as any shareholders of offshore drillers or dry bulk carriers will verify.
Still, for 2016 P/B as an investment metric has outperformed other ratios, particularly in the small-cap stock arena. Chris Meredith of O’Shaughnessy Asset Management highlighted this in a recent research note to clients in which he also took a look at how effective the P/B ratio is as a valuation metric for value investors and its pitfalls as well as benefits.
How helpful is the P/B ratio?
Meredith’s biggest concern with the P/B metric is the possible “distortion” of the figures that can lead to poor stock picks. P/B is a fairly easy ratio to distort; both the numerator and denominator can be manipulated to give a misleading metric that will have the effect of making a company look cheap or expensive relative to its peers.
It is the denominator that is the subject of Meredith’s note. Specifically, Meredith is concerned about the effect of stock repurchases on the P/B ratio:
“There are structural challenges to the factor, and before using it investors need to be made aware of the embedded noise from repurchases that could be misleading.”
A moderate increase in shareholder transactions or stock buybacks could result in the P/B ratio gradually becoming ineffective as a valuation factor according to Meredith. According to the research conducted by O’Shaughnessy Asset Management, repurchasers (those companies that serially repurchase their shares have an “average price-book of 4.5, almost 20% higher than the median 3.8 while diluters look cheap with a price-book of only 2.7 – an apparent discount of almost 30%.” Nonetheless, at the same time the top 25 repurchasers were found to have better operating valuation metrics (e.g., sales, earnings, EBITDA, free cash flow) than the median, and the top 25 diluters had worse results.
The problems of a false result
The big problem here is the effect a skewed P/B will have on screening. Quantitative managers and investors start with the P/B benchmark as their universe but starting with the Russell 1000 Value could bias you toward companies that look cheap on P/B but are not cheap on other important valuation metrics. This is not the most astounding revelation from the research. The most significant revelation is the fact that there has been no relative benefit to buying companies that look cheap on a P/B, and there’s almost no difference between high and low valuations when investments are focused on companies with share issuance or repurchase activity.
In other words, if you are looking for companies that have a sensible capital allocation program, returning excess cash to investors via repurchases and dividends, waiting for the market to offer you the most attractive valuation may not be the best strategy.
Meredith found P/B to be the least effective in largest cap stocks, which have the greatest volume of dollars affecting book value of equity.
Other metrics may yield better results. Meredith concludes that “using a different valuation metric, such as EBITDA-to-enterprise value, works well – regardless of a company’s activity in issuing or repurchasing shares.”
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