INVESTOR EDUCATION SERIES : THE ART OF INVESTING = IN TROUBLED TIMES = WARREN BUFFET REVISITED = GREAT TIMES TO COME NEXT

THE ART OF INVESTING

IN TROUBLED TIMES

The stock Markets get into an intricate loop when there are Political, economic or social uncertainties that start troubling the country – over a long period of one to two years.

When the UPA Government started their second innings, the track record looked good. India was looking for a five year period of sustained economic progress. There were talks of overtaking China and US in definable periods. Stock markets were reflecting this buoyant mood by moving up steadily, right from the beginning of 2009. The FIIs were investing in India on a big scale – spurred by the progress being made by the Indian companies and the investing atmosphere being created by the various ministries of UPA II Government. Huge but achievable targets were set for various Ministers – and there seemed to be serious working in that direction.

But, then came the scams, scandals and a serious, non-seriousness in dealing with economic problems like inflation, land acquisition etc.

 Scams of never-before-size and never-before-brazenness struck the nation. We will not go into their details here. But, our reputation has taken a severe beating in the International arena. Our position in the corruption Index is becoming more glaring than ever before.

The ineffective tackling of persistent Inflation – food and non food inflation both – is casting shadows on Growth. The causes of this Inflation are more structural and logistical in nature, and not due to excessive money supply in the market. These causes are to be tackled by the Governments at centre and states, through Policy prescriptions and quick actions - of short term and long term nature; RBI monetary Policy, applied several times in the year, is therefore beginning to hurt growth, without in any way, reducing Inflation.

Raising the prices of petrol, diesel, LPG, Kerosene etc  at this point of time – is not adding to any hope that inflation will come down soon.

Government’s bold policies in Budgets in respect of Power, Infrastructure, steel  and oil and Gas sectors etc looked so good – but, these are not translating into tangible results due to many Policy deficiencies. Land procurement / acquisition   for Infra structure projects, power projects and steel projects is coming to a stand still for various reasons . There is no visible Political consensus on this matter but a lot of Politicking is visible.

If Government can come up with a good, strong Lok Pal Bill and with measures for effective land procurement / acquisition – this can be the biggest feather in the cap of this government and of India. Let the corrupt face the Lok Pal music. Corruption in India has to come down drastically from its current monumental proportions.

Transparency in Government functioning has to become the order of the day. If that happens, India’s reputation will go up by several notches in the International arena, even if the Lok Pal unearths a few more scams, if the Government remains firmly against corruption.

None of these problems are difficult to tackle. If sufficient statesmanship is displayed – we can hope that in a year’s time, all this dust will settle and economic progress will gear up well again.

If we can recall the genesis of the turbulence in the Market – it started almost with the scams. So, it can end with the end of scams.

But, if our economy and stock markets continue to be in troubled and uncertain times for a year’s time or more from now – what should the investors be doing in the stock markets?

When the mind is drifting and uncertain – read the Gita, says Adi Sankaracharya. Very truly, Gita contains a number of policy prescriptions for various problems of Life. But, Lord Krishna did not deal with Stock Market problems, which was a much later invention of human greed.

Like in the case of any other scientific analysis, here also there are certain broad Policy prescriptions, from none other than the Oracle of Omaha – Warren Buffet. I take them as coming from Gita. Or almost like that :

Here are a few relevant quotes from Warren Buffet:

Ø  Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.

Ø  You only have to do a very few things right in your life so long as you don’t do too many things wrong.

Ø  Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.

Ø  I buy on the assumption that they could close the market the next day and not reopen it for five years.

Ø  The investor of today does not profit from yesterday’s growth.

Ø  Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.

Ø  If a business does well, the stock eventually follows.

We are in troubled times. Market are moving up or down even by a 500 points  on a single day. How much LOW will the market move down over a year, is difficult to predict. If there are more scams, more inflation, more inept handling of development issues, well, market can nosedive by a 2000 points. Or, if there is more efficient and far sighted handling – markets can move up by a 2000 points. So it is + or – 2000 points for the next one year. I do hope, that natural forces will force down solutions to all problems in the mean time. It is happening even now. So, treat the market forces as your friend and ride on them.

Troubled Times are times of opportunity (for long term Investors) :

What will happen in a 3 year time horizon?  Many Indian companies are on clear, unassailable Growth Path. Some of them have grown over 100 percent or more in the past 3 years – and many of them will grow 100 percent or more, in the next 3 years. Their profits can grow much more than 100 percent. If market comes out of troubled times within 1-2 years, which it will, these Growth companies will reward their Investors with over 100 percent capital appreciation. So, treat the troubled times as your opportunity to Invest in companies with the maximum potential for next 3 years. So, this can be a good time for investing!

Do a Few Things Right :

You don’t need to study all companies and pick out the best of them. You do not need to pick out all the best companies. Pick out sectors which will definitely prosper in next three years. Like Banking, Pharma and IT.  

While Banking is largely Indian, Pharma and IT are producing great Multi-nationals. There are huge growth prospects in all these three sectors for the next decade. You may have a different preference based on your study. Oil and gas is another great sector. Reliance and Cairn may look a little sluggish now – but, have Potential to double their size in 3 years. Sectors like Auto have been recording robust growth in recent years.  Within Auto sector, companies which are multinationals like TATA Motors can see greater growth. 

Within each sector – You must choose companies with the fastest growth rates in last 3 years. It does not matter whether they are the biggest, or medium sized or small companies. Look at their forecasts for future Growth. Look at their expansion plans, M&A Plans etc. So, 3 factors are to be studied minimum – (1) Growth sectors (2) past Growth rates in companies in these sectors (3) Plans for future Growth for these companies. Now, make your selection. This is how you can DO A FEW THINGS RIGHT.

INVEST FOR LONG TERM :

Warren’s Investment philosophy is strictly for long term.  If you make your BUY today – assume that market will shut down for next 5 years and reopen after that. So, no transactions in your stock for next 5 years! In the mean time, your company is making great strides and good profits – just as you expected.  Are you comfortable with these assumptions? If you are - Invest now.

It is very difficult to fail – if you select well like this, for long term Investment.

How big should be your Portfolio?

Warren does not prefer big diversification – to spread risks. If you study well and select well – there are very little risks. Limit your Portfolio to about 10 companies maximum.

INVEST; DON’T TRADE :  

Warren Buffet may have done trading also at  some point of time. But, his firm Policy prescription is – No one gains more in frequent trading, compared to the gains in long term Investing.

The more the frequency of trading, the lesser the returns – is Warren’s strong feeling.

As an Investor, you need patience, not anxiety.  As earlier said – Invest for long term. You don’t need to panic because of the movements in daily charts of market prices – so long as your company is doing well.

This means that – Study the quarterly and annual results of your Portfolio companies very well; but not their daily charts of market prices. If their performance results are very good, don’t bother about market fluctuations. If performance results are bad – then, think of some shuffling. Warren says – if the business does well, the stock will do well eventually.

DON’T SELL OR BUY IN PANIC :

If prices are falling, don’t panic. What matters is – whether the company is doing well. Likewise – if prices are rising, unsupported by any improvement in results – don’t go merely by any market buz, Tit Bits, HOT TIPS etc – and don’t buy on their basis. Solid Fundamentals must be the basis for your buying. If you haven’t seen and studied the fundamentals of a company – it is not worth buying.

YOU DON’T NEED TO BE AN EXPERT :

Like any other subject, stock market Buying also needs some knowledge of stocks, stock markets, economy and related aspects. There are many good Books on the subject. Buy one and read. Understand the Basics. Know some of the most important terms – like EPS, price earnings ratio, price to book value ratio and so on. There are some good articles on these subjects in this Blog itself. Go through them to understand them. I list below the minimum factors you must study in respect of the companies you want to invest in.

SALES & PROFITS : It is not difficult to spot companies that are growing in terms of both sales and profits in the last 3 years. Select such companies. If only sales are growing and not profits, or, if only profits are growing but not sales, avoid such companies.

EPS Growth : Amongst the above - Some companies have great EPS right now. But, their EPS is stagnating for some reasons (like bulging equity) and  not Growing for the last several quarters. Avoid companies that are not growing in terms of EPS. Some companies may have smaller EPS, but the EPS may be growing at a fast pace. They are preferable.

PRICE-EARNINGS RATIO : Among the above companies, study their PE Ratios. Select companies with moderate PE Ratios. If PE Ratios are too high, scope for future appreciation is generally LOW. If PE Ratio is too LOW, the market perception about them is dismal. Some times they tend to stagnate at same levels for several years. Some Managements have low reputation and their companies tend to have Low PE Ratios. Read the article on these topics in this Blog for further knowledge.

There are many other ratios like Price to Book Value Ratio etc. But, this Blog considers the above four parameters ,viz., Sales Growth, Profits Growth, EPS Growth, PE Ratio – as the more important ones, indicative of the Potential of the company. If these are all consistently growing well in last 3 years, the company can be generally considered as a growth company. Beyond these – you need to look at Management reputation, Company’s future plans for expansion etc and if these are sound – select them for investment.

WHEN WILL YOU SELL :

Warren says – our ideal holding period is FOREVER. If your company is giving you good capital appreciation and good dividends – keep on holding it. If the company is getting into bad times for any reason – like government Policy (like land acquisition), excessive competition(Like Telecom), Saturation in demand (say, sugar) etc – analyze the causes – and get out of it , if there is no solution to these problems in sight for a long time. But, if there is a solution (like Bharti expanding into other countries), one may continue to hold.

Remember – you don’t love a company – you love the capital appreciation and dividends that you get. This is the general rule.

You are in the stock Market to earn well and profit. This is Rule No.1. Not to lose. If you are losing, remind yourself of Rule No.1 constantly. This is Rule.2.

In troubled times – review your investments. Treat the time as opportunity for fresh investments. If your companies are doing well, don’t bother about troubled times. Don’t bother about market prices. Don’t panic.

Fantastic times are round the corner. These act in cycles always. So, Great times are bound to come after troubled times.

Investing in troubled times is as simple as that. 

PS : Read Also the January Post on this at :

http://wiseinvestmentideas.blogspot.com/2011/01/investor-education-series-when-stock.html

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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:

http://wiseinvestmentideas.blogspot.com/2010/01/money-fascinates.html

2.  MARKET INVESTMENT : ESSENTIAL RULES FOR SUCCESS:

http://wiseinvestmentideas.blogspot.com/2010/01/stock-market-investment-essentail-rules.html

3. SELECTING A GOOD SCRIP FOR INVESTMENT

http://wiseinvestmentideas.blogspot.com/2010/01/selecting-good-scrip-for-investment.html

4. INVESTMENT STRATEGIES OF WARREN BUFFET: (5 ARTICLES)

http://wiseinvestmentideas.blogspot.com/2010/02/investment-strategies-of-warren-buffet_05.html

http://wiseinvestmentideas.blogspot.com/2010/02/investment-strategies-of-warren-buffet_05.html

http://wiseinvestmentideas.blogspot.com/2010/02/investment-strategies-of-warren-buffet_04.html

http://wiseinvestmentideas.blogspot.com/2010/02/investment-strategies-of-warren-buffer.html

http://wiseinvestmentideas.blogspot.com/2010/02/investment-strategies-of-warren-buffet.html

6. WORDS OF WISDOM FROM WARREN BUFFET:

http://wiseinvestmentideas.blogspot.com/2010/05/warren-buffet-wisest-stock-market-guru.html

7. DOLLAR (RUPEE) COST AVERAGING :

http://wiseinvestmentideas.blogspot.com/2010/05/win-with-dollar-rupee-cost-averaging.html

8. PRICE TO EARNINGS RATIO :

http://wiseinvestmentideas.blogspot.com/2010/05/price-earnings-ratio-investor-education.html

9. GROWTH STOCKS vs VALUE STOCKS :

http://wiseinvestmentideas.blogspot.com/2010/06/growth-stocks-value-stocks-two-great.html

10. CANSLIM TECHNIQUE :

 http://wiseinvestmentideas.blogspot.com/2010/06/investor-education-canslim-technique.html

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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