Wednesday, June 27, 2007

A closer look at P/B valuation 1 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
The most common stock valuation method is the PE, or price/earnings ratio. But it is often not a useful measure where cyclical companies are concerned. This is unfortunately the case for many companies in Singapore, for example the hot theme of the moment -- property stocks. Often, the best reality check figure in such cases is the price/book ratio (also see "Non-PE stock valuation metrics").

As a reality check figure, when will P/B be considered high? It really depends on the sector of concern (eg. service companies tend to have higher P/Bs because their main assets --- human capital, is not capitalised), and one way is by comparing with sector peers. The next reality check is via comparison with historical mean P/B.

The latter historical comparison is the basis for Citibank's downgrading of Singapore market equities as a group several days back, which has been blamed for the significant market correction these few days. The fact that market P/B ratio was high compared to historical trends was suggested as indicating that Singapore stocks were overvalued. To a certain point this is reasonable, according to the law of reversion to the mean. However, on another level, the intricacies of the "correct" P/B ratio are worth exploring.

P/B ratios, and indeed most valuation ratios in general, have a close relationship with return on equity (ROE), which is basically the profit that can be yielded per unit of book value. One can take it that the "correct" P/B ratio varies directly with ROE of a company. If we use the Dupont model of splitting ROE into its component factors:

ROE = Profit margin X Asset turnover X Leverage

(Asset turnover = Sales/Total Assets)

we can identify the main operational/financing factors that drive ROE of a company, and hence its "correct" P/B ratio. It is not my intention here to suggest that the secular trend for ROE has risen over that of its historical mean; I don't have the statistics to prove that it is so. However, it is important for the individual investor to consider the main driving factors as listed above, and then think for himself whether we still dogmatically follow historical figures as a guide. In particular, one should examine the period over which the "historical mean" was derived (remember that the last few years before 2004 contained the Asian financial crisis followed by several years of recession) and consider whether current trends for profitability might revert to past averages, remembering that economic structure might differ significantly from the past (eg. electronics being no longer as important, new emerging industries driving growth). At the same time, capital structure and balance sheets are generally acknowledged to be less leveraged than before, which suggests there is capacity for improving ROE further by taking on more debt. So firstly, is the "historical P/B mean" derived in a comprehensive manner, and secondly, is it reasonable that reversion to this mean should take place over the medium to long-term? Or does a new paradigm of emerging Asia justify a higher equilibrium P/B that supports future valuations? These are questions that the individual investor should ask himself in response to such macro calls, instead of just following them blindly.




Anonymous Penny Stock Newsletter said...

The only sure way to know if a stock is undervalued is to look for a low price to sales ratio.

11/24/2012 8:50 PM  

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