Is book value still reliable in investing?

Found an useful article from TheStar, to share with all fellow traders.

Even though we are close to the period of year-end window dressing by institutional fund managers, the recent low market trading volume may imply that a lot of retailers are still quite concerned over the US' financial health, especially on the subprime issue.

After the implementation of new Financial Reporting Standards on Jan 1, 2005, the book value of a company has become more reflective of the actual cost of the shareholders’ wealth in the company as a result of a lot of write-downs and impairment on certain assets for some listed companies over the past three years.

Price-to-book value (P/BV) is derived by dividing the market price with book value per share (BV per share = shareholders’ funds/total outstanding shares of the company).

Alternatively, some analysts may choose to use price-over-net tangible asset per share (P/NTA) instead because the NTA per share provides the total value of the assets net of all intangible assets (mainly goodwill) and all liabilities before dividing the amount by the number of shares. In this article, we will use the term P/BV to reflect the general concept of either P/BV or P/NTA.

How to use P/BV

P/BV reflects the number of times the share of a company is being traded versus the owner’s cost. For example, if Company A has a BV per share of RM2 and its market price is trading at RM2.40, its P/BV will be calculated at RM2.40 divided by RM2 or 1.2 times of its BV per share. According to Benjamin Graham’s defensive value investing method, we should target for stocks that are selling at prices below 1.5 times BV.

In general, we may use this “1.5 times” as a basic guide, but it’s better not to treat it as a foolproof number. In Malaysia, there are many good companies with a P/BV of more than 1.5 times.

The main reason for high price with low BV is because these companies tend to reward their investors with high dividend returns. As a result, their BV always stays low but their dividend yield (DY) is much greater than fixed deposit rates or the industry average. Hence, there is no fixed multiple for this method. The appropriate multiple will depend on how we view the quality of the company’s management and its earnings potential.

In principle, it is quite impossible to buy a stock that is selling at below its BV per share. If the market price is too low compared with its BV, the owner may come in to buy back the shares, as the company’s worth is much more than the market value.

However, in Bursa Malaysia, there are certain companies that are always selling below their BV because the general public has less confidence in the quality of its management. Hence, we should not buy a stock just because it has a low P/BV.

According to Warren Buffett’s “cigar butt” approach, a cigar butt found on the street that has only one puff left in it may not offer much of a smoke, meaning the so-called “bargain purchase” may not turn out to be such a steal.

Most of the time, a company is selling at a distress level due to weak earnings prospects, and any further deterioration in earnings may deplete its remaining BV. Thus, Buffett postulated that we should buy stocks based on their earnings potential instead of their attractive BV.

P/BV is an appropriate measure of the net asset value of firms that hold liquid assets primarily. The value of liquid asset is more definite than the real property value. Examples of such companies are those in finance, investment, insurance, and banking.

As long as these financial institutions make enough provisions for all their bad and doubtful loans, their real asset values should be near to their BVs. As a result, we will notice that it is quite difficult to find a banking stock selling near or below its BV. Most of the time, they are trading at a premium to their BVs.

(This article is available on TheStar, http://biz.thestar.com.my/news/story.asp?file=/2007/12/5/business/19662755&sec=business, by Ooi Kok Hwa, who is an investment adviser and managing partner of MRR Consulting.