Value investing enables investors to identify stocks the broader market may have overlooked, buying quality companies at relatively inexpensive valuations.
While the price-to-earnings (P/E) and price-to-sales (P/S) ratios are among the most widely used valuation metrics, the price-to-book (P/B) ratio is another simple and effective tool for uncovering undervalued stocks with solid long-term growth potential. The P/B ratio measures a company's market value relative to its book value, helping investors assess whether a stock is trading above or below the value of its net assets.
The P/B ratio is calculated as:
P/B Ratio = Market Capitalization ÷ Book Value of Equity
This metric can help identify attractively priced stocks with upside potential. Some such stocks are PagSeguro Digital PAGS, USANA Health Sciences USNA, General Motors GM, Nexa Resources NEXA and Avnet AVT. Let us understand the concept of book value.
What is Book Value?
There are several ways in 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 went 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.
Book Value Per Share = (Total Assets – Total Liabilities) ÷ Number of Outstanding Shares
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. Like P/E or P/S ratios, it is always better to compare the P/B ratio 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 warning. A P/B ratio of 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 such a 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 is not 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.
Screening Parameters
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.
5 Low Price-to-Book Stocks
Here are five of the 12 stocks that qualified for the screening:
São Paulo, Brazil-based PagSeguro Digital is one of the largest digital banks in Brazil, promoting innovative solutions in financial services and payment methods.
PAGS currently has a Value Score of A and a Zacks Rank #2. PAGS has a projected 3-5-year EPS growth rate of 14.9%. You can see the complete list of today’s Zacks #1 Rank stocks here.
USANA Health Sciences develops and manufactures high-quality nutritional, personal care and weight management products. USANA Health Sciences currently has a Zacks Rank #2 and a Value Score of A. USNA has a projected 3-5-year EPS growth rate of 12.0%.
Detroit, MI-based General Motors is one of the world’s largest automakers. General Motors, along with its strategic partners, produces, sells and services cars, trucks and parts under four core brands — Chevrolet, Buick, GMC and Cadillac. General Motors assembles passenger cars, crossover vehicles, light trucks, sport-utility vehicles, vans and other vehicles.
GM currently has a Zacks Rank #2 and a Value Score of A. The company has a projected 3-5-year EPS growth rate of 15.5%.
Luxembourg City, Brazil-based Nexa Resources is an integrated zinc producer. It is engaged in developing and operating mining and smelting assets, primarily in Latin America. NEXA currently has a Value Score of A and a Zacks Rank #1. NEXA has a projected 3-5-year EPS growth rate of 15.7%.
Based in Phoenix, AZ, Avnet is one of the world’s largest distributors of electronic components and computer products. The company’s customer base includes original equipment manufacturers, electronic manufacturing services providers, original design manufacturers and value-added resellers.
Avnet has a Zacks Rank #1 and a Value Score of B. AVT has a projected 3-5-year EPS growth rate of 43.3%.
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Avnet, Inc. (AVT): Free Stock Analysis Report
General Motors Company (GM): Free Stock Analysis Report
USANA Health Sciences, Inc. (USNA): Free Stock Analysis Report
Nexa Resources S.A. (NEXA): Free Stock Analysis Report
PagSeguro Digital Ltd. (PAGS): Free Stock Analysis Report
This article originally published on Zacks Investment Research (zacks.com).