In recent Danger Zone reports, I have highlighted how price-to-earnings ratios and return on equity (ROE) mislead investors. This week, I look at another metric that’s misleading potential value investors.
The price-to-book (P/B) ratio is one of the oldest metrics in the value investing handbook and one of the most widely used to this day. FTSE Russell, one of the largest index providers in the world, uses P/B as the primary metric to distinguish value stocks from growth stocks. Unfortunately, changes in accounting rules and the types of assets that create value for companies have made P/B a poor measure of value. Investors who still rely on P/B (including anyone in a value index fund) are in the danger zone.
No correlation between P/B and profitability
I originally investigated the errors in January 2016 using the accounting book value. I found that on the surface P/B and ROE appear to be closely related, but once you removed outliers, the r-squared dropped to just 27%. When I run the regression today, outliers are removed againROE explains only 21% of P/B differences among S&P 500 companies.
Figure 1: ROE vs. P/B for the S&P 500
Of course, as I noted in a previous article on Danger Zone, ROE is misleading as it relies on erroneous accounting revenue. Instead, let’s look at P/B versus the truest measure of profitability, return on invested capital (ROIC).
Figure 2: ROIC vs. P/B for the S&P 500
As Figure 2 shows, the r-squared value for ROIC and P/B is only 7%. The two metrics have almost no connection. Since we know that ROIC is the primary value driver, this suggests that P/B is not a good valuation metric.
Flawed metrics cause value strategies to underperform
Given the shortcomings of the P/B, it should come as no surprise that so-called “value indices” have struggled over the long term. Over the past 15 years, the iShares Russell 1000 Value ETF (IWD) is up just 115%, while its growth counterpart (IMF) is up 207%. This long-term underperformance has led to much speculation about the “death of value investing.”
The reality is that value investing isn’t dead, it just needs updated metrics.
Book value can be misleading
Accounting book value suffers from these major flaws when it comes to valuing stocks:
- The book value can be written down at any time at management’s discretion.
- Companies can hide both assets and liabilities from the balance sheet so that they are not reflected in the book value.
- Accounting rules are designed to best estimate liquidation value for debt investors and not to measure capital employed to generate returns, which is important for equity investors.
Because shareholders’ equity and book value are the same, both ROE and P/B rely on the same accounting construct, making them equally unreliable for equity investors.
The risk of depreciation
Mergers and acquisitions are among the most common sources of artificial book value. When a company buys another company at a premium to its market value, the excess purchase price is recognized as goodwill. Goodwill is recognized as part of accounting book value, but is often amortized if the acquisition falls short of expectations.
Write-offs (also known as depreciation) are very common. 53% of all acquisitions result in value destruction, and I’ve found tens of thousands of write-downs totaling over $1 trillion in the files I’ve analyzed, dating back to 1998. Depreciation, in particular, tends to rise when the market’s valuation deviates significantly from economic book value (EBV), the zero growth value of current cash flows.
Figure 3: Impairments from 2000
Investors who thought they owned cheap stocks based on P/B get a rude awakening when the market crashes. In a bear market, cash flows matter most, and when a company isn’t generating the cash flows to support the book value of its assets, those assets are written off.
Sears Holdings (SHLDQ) is a good example of this risk. When I first wrote about Sears in 2013, the stock had a relatively low P/B of 1.8. However, $3.3 billion (35%) of the book value came from goodwill and other intangible assets such as brand names. In the years that followed, most of these intangible assets were amortized. Investors who thought they had a margin of safety due to the low P/B ended up losing 89% of their investment.
Figure 3 also helps explain why a value strategy has underperformed since 2003 after beating the market for years. In 2002, the Financial Accounting Standards Board (FASB) switched from a system of goodwill amortization to goodwill impairment. Prior to 2002, companies that made acquisitions regularly amortized goodwill on their balance sheets, regardless of the completion of the acquisition. This meant that companies regularly reduced their goodwill on the balance sheet and prevented the book value from inflating.
After 2002, companies no longer had to amortize goodwill, but only had to test it annually for impairment. This change led to the pattern in Figure 3, in which companies overstated goodwill and bloated their balance sheets for years until a market crash finally forced them to wipe it out entirely.
This change in accounting rules isn’t the only factor that has caused the value to underperform over the past 15 years, but it is a significant and underappreciated factor.
Hidden assets and liabilities further cloud the picture
I make several adjustments to convert total assets into invested capital as companies can hide assets and liabilities in the form of reserves, operating leases, deferred compensation, etc. from the balance sheet.
These off-balance sheet arrangements mean that the shareholders’ equity line ignores a significant portion of the resources a company uses to conduct its operations.
In addition, the carrying value of intangible assets varies significantly depending on whether a company acquires them or develops them organically. Colgate-Palmolive (CL), which I featured earlier this year as a hidden value gem, has negative book value because its most valuable assets are brands it has developed over its hundred-plus years of existence. Meanwhile, its competitor Procter & Gamble (PG) looks cheaper on a book-price basis due to the goodwill on its balance sheet from its multiple acquisitions. The two companies have similar businesses, but one looks significantly cheaper than the other due to flawed accounting constructs.
The liquidation value has limited value for stock investors
Book value is meant to measure the potential assets available to investors in the event of liquidation, and that figure just isn’t a very useful measure for most stock investors. If you buy stock in a company that’s going into liquidation, you probably book it as a failed investment.
Even the idea that a low price to book limits your potential downside is flawed. Depreciation or hidden charges can drive a stock price below book value, as can a company that has a negative return on invested capital (see Sears above).
The accounting standards were originally developed for use by debt investors. Equity investors should not expect the financial statements prepared under these rules to contain figures that accurately reflect their concerns.
A better measure of value
Instead of P/B, I prefer to use Enterprise Value divided by Capital Invested (“EV/IC”). Invested capital includes all of a company’s operating assets, both on and off the balance sheet, and is not easily skewed by a company’s capital structure. As Figure 4 shows, the r-squared value for ROIC vs. EV/IC is a much higher 53%, and we don’t have to eliminate pesky outliers in this regression.
Figure 4: ROIC vs. EV/IC for the S&P 500
Importantly, investors still need to pay attention to ROIC when considering valuing a company. Allergan (AGN), highlighted in Figure 4, has a book price of 0.74 and an EV/IC of 0.76. Those low numbers could lead investors to believe the stock is cheap.
However, a quick look at the balance sheet reveals that $98 billion of AGN’s assets (92% of total assets) come from goodwill and other intangible assets. The company’s low ROIC of just 0.4% suggests these intangible assets are significantly overvalued and investors should watch for future impairments. If AGN were trading at its fair value based on the trend line in Figure 4, the stock would be worth just $67/share today, down 57% from the current price.
On the other side of the coin, Qualcomm (QCOM) could look expensive given its P/B of 75. However, the stock has a much more reasonable EV/IC of 5.2, and considering its 26% ROIC, the stock looks downright cheap. If QCOM traded at the valuation implied by the trend line in Figure 4, it would be worth $65/share today, up 14% from current price.
QCOM’s book value may be low, but the company has valuable assets, such as technology know-how and customer relationships, that are not recognized on the balance sheet. These assets help the company achieve a superior ROIC and justify a much higher multiple of the invested capital.
No number can tell the full story of a business, especially when that number is as flawed as the price to book. Investors deserve conflict-free and comprehensive fundamental research and should look to more sophisticated metrics and analysis that offer a more accurate measure of value.
Value investing isn’t dead as long as you have the research to handle the growing complexity and volume of today’s accounting disclosures.
Disclosure: David Trainer, Kyle Guske II and Sam McBride are not compensated to write about specific stocks, sectors, styles or topics.
 Any company with a P/B below -100 or above 100.