## Wednesday, November 17, 2010

### INVESTOR EDUCATION SERIES = PRICE TO BOOK VALUE (or) PB RATIO = A GOOD METRIC = TO BE USED ALONG WITH PE RATIO = IN STOCK ANALYSIS

INVESTOR EDUCATION SERIES
PB RATIO

Earlier Articles in CUSTOMER EDUCATION SERIES  can be read at the following URLs :
1.    MONEY FASCINATES:
2.  MARKET INVESTMENT : ESSENTIAL RULES FOR SUCCESS:
3. SELECTING A GOOD SCRIP FOR INVESTMENT
4. INVESTMENT STRATEGIES OF WARREN BUFFET: (5 ARTICLES)
6. WORDS OF WISDOM FROM WARREN BUFFET:
7. DOLLAR (RUPEE) COST AVERAGING :
8. PRICE TO EARNINGS RATIO :
9. GROWTH STOCKS vs VALUE STOCKS :
10. CANSLIM TECHNIQUE :
PRICE TO BOOK VALUE RATIO
Price to Earnings ratio and Price to Book value ratio are the two most frequently used ratios in stock investment analysis today. We have covered Price Earnings ratio in an earlier Blog Post.

In this Post, let us examine Price to Book value Ratio in detail. First, we will look at a simple example which can illustrate this Ratio.

EXAMPLE.1 :
Suppose you Buy a House, by pooling  -
(a) your own money of Rs.50 lakhs and
(b) a Loan from a Bank, of Rs.50 lakhs.

The Gross value of the house is Rs.100 lakhs (or, Rs.10 millions). If you maintain books of accounts for this House,  as a company, this is the gross asset value you will reflect in your Balance sheet (on the assets side) – for this House Asset.

But, what is its Net Value to You, the OWNER  of the house?

It is Rs.50 lakhs (or, Rs.5 million), the difference between the gross asset value of  Rs.10 mn (-) Rs.5 mn liability against the house.

You have rented out the house for  Rs.1 lakh rent per annum and placed the received rent in a Fixed Deposit earning  interest @ Rs.50,000 p.a.

Let’s say - Depreciation for the house is Rs.50,000 p.a.
You are repaying the loan at the rate of  Rs.50,000 p.a.
After 10 years, the gross and net values of the House will be  as below :
(a)  Gross Value of the House : Rs.100 lakhs (or Rs.10 million).
(b)  INCOMES FROM THE HOUSE:-
a.    Rents received for 10 years : - Rs.10 lakhs.
b.    Interest on Rents in FD received for 10 years : - Rs.5 lakhs
c.    Total income from the house : b + C : - Rs.15 lakhs.
(c) EXPENSES ON THE HOUSE :-
a.    Depreciation on the house : Rs.5 lakhs (Rs.50000 p.a.  X 10 years).
b.    Assume that  interest paid on the loan is:  Rs.5 lakhs.
c.    Total Expenses on the House : Rs.10 lakhs
(d)NET INCOME FROM THE HOUSE :-
Total income of Rs.15 lakhs  (-)Total Expenses of Rs.10 lakhs   =  Rs.5 lakhs (Net Income)
(e) LOAN OUTSTANDING AGAINST THE HOUSE:-
a.    Gross amount of loan (Liabilities) :-Rs.50 lakhs.
b.    You have repaid Rs.5 lakhs out of this (Rs.50,000 p.a. X 10 years).
c.    loan / liabilities outstanding :-  Rs.45 lakhs.
(f)  NET VALUE OF THE HOUSE FOR YOU  :- Gross value of the house (Rs.100 lakhs) + Net Income from the house of Rs.5 lakhs – Net loan outstanding of Rs.45 lakhs) = Rs.65 lakhs.
(g)Your original contribution to the house (or, your equity capital to this company) was Rs.50 lakhs.  But your company today is worth Rs.65 lakhs as per your company’s Books of accounts after adding all incomes such as rent and interest and after deducting total accumulated depreciation (and of any other expenditures like maintenance)
(h)Book Value of the House is therefore :  Rs,65 lakhs.
(i)  We do not consider here the market value of the House – as it is not reflected in Company balance sheet.
(j)  Let us now divide your company’s equity into 50 lakh equity shares, each of Rs.1.
(k) Book Value of each equity share of the face value of Rs.1 of  your company today  is :- {Rs. 65 lakhs divided by 50 lakh shares} =  Rs.1.3.
(l)  So, Rs.1.3 is the Book value per Equity share of  your company.
(m)               Now, assume that  you have listed your company on the stock exchange and the shares are tradable on the exchange. Suppose your shares are being traded at the exchange at Rs.2 (per each equity share of the face value of Rs.1).
(n)Now, the PRICE TO BOOK VALUE RATIO, or simply  PB Ratio  of the company = Market Price of the Share divided by the Book Value of the Share = Rs.2 / Rs.1.3 = 1.54. This PB Ratio is only a ratio and not in Rupees or any currency.
(o) The Market value of the share is reflected by the market price of the share for listed companies. Book value is computed as indicated above. Market Price to Book Value reflects the confidence of the Investors in the company on the future profitability of the company.

What does this PB Ratio of  1.54  indicate to you?

It means, Book value of the company is viewed positively by Investors, to yield good profits in future and that they are willing to pay more for the stock than its intrinsic book value. If  PB Ratio is more than 1, it generally means that Investors are inclined favourably towards the company’s future.

But, suppose, your company’s shares are traded at  Rs.1.1 even though Book value of each share is Rs.1.3. Then, the PB ratio is Rs.1.1 / Rs.1.3 = 0.92, which is less than 1. This implies that  investors do not expect your company to be very profitable in future and they are not willing to pay even the intrinsic Book value for each share of your company.

Now, we need to look at 3 values of your company shares and then, look at the PB Ratio of your company.

Face Value of the Share :-   Rs.1
Book Value of the share :-   Rs.1.3
Market Value (Price) of the Share:- Rs.2
PB Ratio :- 1.54.

Of what use is the PB Ratio for Investors in various listed  companies?

Face Value of the share is an indicator of the original contribution by Investors at the start of the company for EACH SHARE  of the company. Book value reflects the growth of the company in the Past. It reflects the value available to the equity Investors of the company, in case of dissolution of the company. It reflects the approximate worth of the company for prospective investors of the company.
But, Market value or Market Price of the share which keeps on varying from day to day depends partly on book value and partly on many other factors, including (i) demand and supply of the shares in the market and (ii) expected future profitability of the company. The expected future profitability of the company itself depends on many factors and becomes highly subjective. The only thing certain about the Future, as we all know, is its UNCERTAINTY.

Yet, we all try our best, based on what we know of the present and the past, to predict the future trends. The present price of a stock is the result of such predictions of all the investors of the company.
We have three values namely, Face Value, current Book value and current Market Price. Based on them, we can calculate the PB ratio very easily by the formula PB Ratio = current book value / current Market price. Usually Book value is available as at the end of last accounting year. But, many companies are now publishing unaudited information on quarterly basis about Balance sheet values, and Book values.

While PB Ratio of a company is good information by itself – comparison of PB ratios of  many companies in the same Industry yields better information for stock Investment.

If PB Ratio is  less than 1 : –
Generally, the company may be having some problem not visible to us on balance sheet. Its management may not be reputable. Or, the Company’s products may not have much scope of selling in the market in future. Its expansion scope may be limited. Its profitability is likely to take a dent in future. Its past performance may have been sliding from a higher to a lower Profitability level and expected to slide further. Many such adverse reasons can pull down the PB ratio to less than 1. Investors need to look for such reasons. If there are no buyers at all for a stock in the market, which also may happen for companies, Price may be zero and PB ratio also may be zero. Please note that PB ratio is never negative.

If, even after all careful analysis, you find no such adverse reasons – then, it may be that – the company is YET TO CATCH THE EYE OF THE INVESTORS. This also is quite possible. These can give us good returns when they catch the fancy of all investors in due course. Market will certainly recognize good companies in course of time. If you are an early bird, you catch the company shares at a LOW PRICE today and reap wind fall profits when the others also notice the good company and start buying its shares. It is one of the PENNY STOCKS - with a golden touch. You may be the fortunate one to have noticed its huge future scope so early.

If PB Ratio is more than 1 : –
It means, usually, that the above negative aspects are not present and Investors view the company as a healthy company. It is a profitable company. But, still, you need to compare it with similar companies in the same Industry to.

EXAMPLE.2 :-
Let us take the example of Indian Public sector Banking Companies . The PB Ratios of these Banks range between 1.37 to 2.92 according to a recent analysis.  This indicates (i) All these banks with PB ratio above 1.3 are reasonably healthy and profitable. (ii) Of them, some with higher PB Ratios are more preferred by Investors than others  with Lower PB Ratios. It also indicates the relative profitability of these banks – with some exceptions.

If Bank A having a PB ratio of 1.6 today, has produced a much better quarterly result than bank B which today has a PB ratio of 1.9. Investors take a fresh and careful look at bank A now. If Investors are convinced that these better results reflect a trend rather than one of a kind – Investors tend to shift from Bank B which has a higher PB ratio of 1.9  to the Bank A, which has a lower PB ratio of 1.6 as of today. The expectation of Investors is that Bank A, which has now moved to a higher profitability level will command a higher price and a higher PB ratio in due course and who ever buys at current lower price stands to benefit in future.

This yields not only an immediate profit for the investor but the rising profitability of Bank A will yield greater profits in future. Now, let us move to a different level of comparison in the following example.

EXAMPLE.3:

Can we compared the same Bank ‘A’ (or, B)in the public sector Banking Industry, with Bank  ‘M’ or ‘N’  in the Private sector Banking  Industry?

In the Indian private sector  Banking Industry, PB ratios range much higher - from 1.4 to 7.7. Why so?

The Private sector players traditionally have huge freedom in operations which is not available to Public sector players. They are considered more efficient and faster in attracting  deposits and giving advances and offering a host of other services. They  use more automation techniques and less people and less Branches for the same level of Business.

They can attract highly efficient top managers and lower level personnel, give them requisite freedom in operations and management and higher remuneration – all of which are not feasible in Public sector banking. So, future growth and future profitability is perceived as much faster in private banking. Hence market prices (compared to Book values) are higher in private Bank stocks compared to public sector banks.

In recent years, this paradigm has been changing.  Public sector banks have gone in for the latest automation techniques, which are in some cases even superior to private sector banks, reduced their staff strengths considerably, gone in for campus recruitments for highly qualified personnel, improved managerial remunerations, given higher freedom to them and taken many steps to stabilize and improve their operations. Another psychological factor has also come into play after the 2007 – banking crisis in US and other countries. Deposits have shown greater preference for Public sector banks than earlier, in view of the greater security therein, greater governance standards in them, and most importantly, their consistently rising profit  and dividend levels which are now no less than those of private sector banks. Central bank (RBI) controls have proved to be a benefit rather than a curse. The lack of the same controls on private sector banks to the requisite level makes them a riskier investment. These are all factors which have merited better PB ratios for Public sector banks compared to 2 years earlier. It can be expected to rise further.

This example is given in detail – as it illustrates various factors which influence PB ratios from time to time.

Can we compare Banking Stocks with  Other Industry stock such as, Pharma, FMCG, Steel, Other metals etc?

Yes….  And, No.

The Part that Book value plays in the profitability of a company varies from Industry to Industry. In a software Industry, Book values are abysmally less while profitability is very high. IT industry depends more on its intellectual software and less on Book values of tangible assets. For instance, Infosys has a PB ratio of around 7.81 and TCS has an even higher PB ratio of around 13.78. In their case, PB ratio is not that much meaningful. Price Earnings Ratio is a better tool for them.

In a steel Industry, Book value plays a greater part.

In Banking Industry, it has a good part but not as much as in some capital intensive industries. Again – Banking Industry is shifting significantly to Automation, outsourcing and other techniques which reduce its dependence on Book Values of physical assets. Hence, its profitability will rise more independently of its Book values. Which means, more the automation and outsourcing, less is the usefulness of PB ratios.

So, while comparing PB ratios across Industries, we need to take into account the relative part played by Book value of assets in generating profits, earnings per share and finally resulting in  market price of the share.

This explains the ‘NO’ answer above.

Yet, PB values do help comparison even across Industries. In some Industries, PB ratio values are rising. In some others they are constant. In yet others, PB ratios are falling.
Where PB ratios are rising over time, it indicates rising investor confidence in those Industries.
Where PB ratios are constant, it indicates stable rise of profits along with creation of assets.
Where PB ratios are falling, it may be due to falling profitability despite creation of assets, and probably, presence unused / underused capacities.

Can PB Ratio be a sole guide for investing?

The answer is No.

PB ratio is a good supplement to other important ratios like Price earnings ratio, Price to sales Ratio etc.

To a certain extent – it can be said that since (i) Book values result in sales (ii) sales result in Profits (earnings) and (iii) earnings reflect the effect of Book values, sales and many more factors than Book values, Price to earnings Ratio already reflects the effect of the underlying PB ratio.

A lower PB ratio and a lower PE ratio together can indicate good earnings and good book value and yet lack of rise in market price of the stock. Some times, it can be due to poor management quality, not fancied by Investors. But, if  such reasons are not present – such stocks, with lower PB ratio and lower PE ratio are the once, which can yield the best results for investors.

What about Stocks with HIGH PB RATIOS AND HIGH PE RATIOS?

The rising Book values are already discounted in the higher price. Likewise, the rising earnings also are discounted in the higher price.

It shows investor confidence in the companies. It may also imply that investors expect the future of these companies to be much better than the present. It may also imply that the company is implementing a huge expansion program which is expected to add hugely to its book values in near future and consequently (a little later) to its sales and to its profits and thereby, to its market price. Traditionally companies with long gestation periods but with assured future profitability (like Power sector, Infrastructure sector) tend to have  High PB ratios and high PE ratios. As we have also seen, IT companies with LOW Book Values and high profitability also tend to have high PB ratios and High PE Ratios.

If such positive factors are not present, the stock may be in a pure speculative phase and needs to be avoided by Investors.

In such cases, an additional ratio such as Price to Sales ratio also helps us to clear our perception about the stock.

What about Stocks with LOW PB RATIOS and LOW PE RATIOS?

As discussed earlier, these are un-fancied stocks. Neither a good Book value nor good current earnings enthuse the investors to buy these stocks. In the ultimate analysis stock price is a function of demand and Supply. Demand is created by  Book values, sales and earnings. More important is future expectation. Unfancied stocks with less reputed managements have less future expectation. Hence, they enjoy low PB Ratio and Low PE Ratio.

On the contrary – a High PB ratio and a Low price earnings ratio indicates that the while the book values are discounted in the higher price, the rising earnings are not discounted in the price. There is no direct one to one relationship between book value and earnings in such cases. Earnings rise faster than Book values and prices. Hence, PE Ratios are lesser. In due course, PE ratios rise faster and PB ratios may stabilize.

Do Book Values Always move in sync with Prices?

No. It is not necessary that  Book values should move in sync with prices always.
There are many pit falls in directly linking Book values with Prices. These are discussed below ;

1. Book values of assets purchased earlier tend to be less due to lesser costs in earlier days and higher accumulated depreciations as on today. Their earning Power may however be equal to more recently bought assets, which may have higher book values and no HIGHER earning power than older assets.
2. Some companies have huge unused assets which are not earning any incomes / profits. Typically public sector companies tend to acquire large assets – some of which may remain less productive or even unproductive. Hence, their Book values cannot be linked to Market prices of their shares.
3. In some companies, lower PB Ratios may indicate falling sales and obsolete products.
4. In some technology intensive industries, technology keeps changes fast. In these industries, later assets may have lower costs and Book values but higher productivity. Here PB Ratios tend to move up, as companies move up to higher technologies having lower Book values of assets.
5. Some companies have deceptively high current earnings – but highly aged assets. In such companies, Book values may be less due to huge accumulated depreciation, but future earning capabilities may also be less even though current earnings are on par with other companies.
6. Capacity Utilisation of assets is a factor weighing heavily on PB Ratio. A company utilizing 120 percent of  its rated capacity  may have a high PB ratio, compared to a company with the same assets ( or same Book values) but with a lower capacity utilization of say 70 percent of its rated capacity.
7. In short, we can say – while Book Value is an important factor in sales, earnings and market price of stocks, the correlation between Book value and price is not DIRECT but is  INDIRECT. Book value must result in sales, sales must result in earnings and earnings must result in Market Prices.
8. It is often said that – book value indicates the amount that you, as equity investor will get, if the company goes into liquidation. This is the oldest and somewhat outdated theory. Book value never indicates current market values of the assets, especially, if the company were to go into liquidation. How many equity investors got any such return of value based on Book values in the world corporate history needs close research. An equity Investor should never buy into equity with this hope. Never buy into a company which is ever likely to go into liquidation – even if it has good Book value of assets.
9. Stock Investing must be done by identifying good growth stocks. We have excellent tools for the purpose like PB ratio, PE Ratio and Price to sales ratio. You must also look at the consistency of these ratios over a period of  3-5 years. This way, you can easily identify good growth stocks in good growth Industries, in good, growth oriented countries/ states.
10. You can use them to identify good penny stocks too.  These Ratios are useful tools. You can use them for a variety of purposes in stock Investing.
11. Are they Useful in speculative stock trading / F&O? F&O activity is more dependent on demand and supply  in those activities.  PB ratio, PE Ratio, PS Ratio  have very less use there.
12. If you want to BUY an existing company as an entrepreneur, one factor you can use is the average PB ratio in the Industry. You can pay a price equivalent to or less than{ the BOOK value of  the company ( X) average PB ratio of the Industry}.
13.  Book value of a share represents a current Status. It  indicates neither the past nor the future. Market price of the Share likewise is a current FACT. While it depends to some extent on Book value, it also depends on current market dynamics (demand and supply). Market prices, based on demand and supply of the shares, can rise  or fall by even 25% or more , without any change in Book values. That is what we call bull runs, bear runs, boom  periods and corrections and so on. Investors, especially short term investors must keep this in mind.
14. For long term investors, these factors not withstanding, PB Ratio, PE Ratio and Price to sales ratio are reasonable indicators  for a sound purchase.
15. Is it better – if PB Ratio is lower or Higher? All other factors being positive, a lower PB ratio indicates that the company stock is under priced. If PB ratio is higher, it may indicate that the company stock  is overpriced.
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