Value investors prefer price to earnings (P/E) and price to sales (P/S) ratios for identifying low-priced stocks with exceptional returns. However, the underrated price-to-book ratio (P/B ratio) is also an easy-to-use valuation tool for the purpose. The ratio is used to compare a stock’s market value/price to its book value.
The P/B ratio is calculated as below:
P/B ratio = market price per share/book value of equity per share
P/B ratio reflects how many times book value investors are ready to pay for a share. So, if the share price is $10 and book value of equity is $5, investors are ready to pay two times the book value. Ideally, a P/B value under 1.0 is considered good, indicating a potentially undervalued stock. However, value investors often consider stocks with a P/B value under 3.0.
The P/B ratio helps to identify low-priced stocks that have high growth prospects. Celestica CLS, ASE Technology Holding ASX, Harley-Davidson HOG, Teck Resources Limited TECK and Hillenbrand HI are some such picks.
Now let us understand the concept of book value.
What’s Book Value?
There are several ways by which book value can be defined. Book value is the total value that would be left over, according to the company’s balance sheet, if it goes bankrupt immediately. In other words, this is what shareholders would theoretically receive if a company liquidates all its assets after paying off all its liabilities.
It is calculated by subtracting total liabilities from the total assets of a company. In most cases, this equates to common stockholders’ equity on the balance sheet. However, depending on the company’s balance sheet, intangible assets should also be subtracted from total assets to determine book value.
Understanding P/B Ratio
By comparing the book value of equity to its market price, we get an idea of whether a company is under-or overpriced. However, like P/E or P/S ratio, it is always better to compare P/B ratios within industries.
A P/B ratio of less than one means that the stock is trading at less than its book value, or the stock is undervalued and therefore a good buy. Conversely, a stock with a ratio greater than one can be interpreted as being overvalued or relatively expensive.
For example, a stock with a P/B ratio of 2 means that we pay $2 for every $1 of book value. Thus, the higher the P/B, the more expensive the stock.
But there is a caveat. A P/B ratio less than one can also mean that the company is earning weak or even negative returns on its assets or that the assets are overstated, in which case the stock should be shunned because it may be destroying shareholder value. Conversely, the stock’s price may be significantly high — thereby pushing the P/B ratio to more than one — in the likely case that it has become a takeover target, a good enough reason to own the stock.
Moreover, the P/B ratio isn't without limitations. It is useful for businesses — like finance, investments, insurance, and banking or manufacturing companies — with many liquid/tangible assets on the books. However, it can be misleading for firms with significant R&D expenditure, high debt, service companies, or those with negative earnings.
In any case, the ratio is not particularly relevant as a standalone number. One should analyze other ratios like P/E, P/S, and debt to equity before arriving at a reasonable investment decision.
Price to Book (common Equity) less than X-Industry Median: A lower P/B compared with the industry average implies that there is enough room for the stock to gain.
Price to Sales less than X-Industry Median :The P/S ratio determines how much the market values every dollar of the company’s sales/revenues — a lower ratio than the industry makes the stock attractive.
Price to Earnings using F(1) estimate less than X-Industry Median: The P/E ratio (F1) values a company based on its current share price relative to its estimated earnings per share — a lower ratio than the industry is considered better.
PEG less than 1: PEG links the P/E ratio to the future growth rate of the company. The PEG ratio portrays a more complete picture than the P/E ratio. A value of less than 1 indicates that the stock is undervalued and investors need to pay less for a stock that has bright earnings growth prospects.
Current Price greater than or equal to $5: They must all be trading at a minimum of $5 or higher.
Average 20-Day Volume greater than or equal to 100,000: A substantial trading volume ensures that the stock is easily tradable.
Zacks Rank less than or equal to #2: Zacks Rank #1 (Strong Buy) or 2 (Buy) stocks are known to outperform irrespective of the market environment.
Value Score equal to A or B: Our research shows that stocks with a Value Score of A or B, when combined with a Zacks Rank #1 or 2, offer the best opportunities in the value investing space.
Here are our five picks out of the 18 stocks that qualified the screening:
Celestica is one of the largest electronics manufacturing services companies in the world, serving the computer and communications sectors.
Celestica has a Zacks Rank #1 and a Value Score of A. Celestica has a projected 3-5 year EPS growth rate of 14.5%.
You cansee the complete list of today’s Zacks #1 Rank stocks here.
ASE Technology Holding is a provider of semiconductor manufacturing services in assembly and testing.
ASE Technology Holding has a projected 3-5 year EPS growth rate of 26.9%. ASE Technology Holding currently has a Zacks Rank #2 and a Value Score of A.
Teck Resources Limited is a diversified resource company committed to mining and mineral development with business units focused on steelmaking coal, copper, zinc and energy.
Teck Resources has a projected 3-5 year EPS growth rate of 38.7%. TECK currently has a Zacks Rank #2 and a Value Score of A.
Harley-Davidson is one of the leading motorcycle makers in the world. It is the parent entity of company groups doing business as Harley-Davidson Motor Company and Harley-Davidson Financial Services.
Harley-Davidson has a projected 3-5 year EPS growth rate of 46.4%. TECK currently has a Zacks Rank #1 and a Value Score of A.
Hillenbrand is a global diversified industrial company with multiple market-leading brands that serve a wide variety of industries across the globe. Hillenbrand's portfolio comprises two business segments: the Process Equipment Group and Batesville.
Hillenbrand has a projected 3-5 year EPS growth rate of 12%. Hillenbrand currently has a Zacks Rank #2 and a Value Score of A.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report HarleyDavidson, Inc. (HOG) : Free Stock Analysis Report Celestica, Inc. (CLS) : Free Stock Analysis Report ASE Technology Holding Co., Ltd. (ASX) : Free Stock Analysis Report Hillenbrand Inc (HI) : Free Stock Analysis Report Teck Resources Ltd (TECK) : Free Stock Analysis Report To read this article on Zacks.com click here. Zacks Investment Research