Expensive stocks may not be so dear after all

Value investors often rely on the price/book ratio as a filter for cheap stocks. New research suggests that's a mistake.

The price/book ratio is a commonly used valuation measure, particularly favoured by value investors. Book value is a measure of a company's assets, less its liabilities. In theory, if you can buy a company for less than the value of its net assets (in other words, the p/b ratio is less than one), then you're potentially snapping up a bargain. If a company is trading for much more than its book value, then you might be overpaying.

The trouble is, it seems the measure has been letting us down. A new paper from Travis Fairchild at O'Shaughnessy Asset Management notes that from 1993 to 2017 firms with negative book value (ie, liabilities apparently worth more than their assets), and companies that looked expensive on a p/b basis, but cheap on other measures, tended to beat the wider market. In other words, if you avoided these stocks on the basis of the p/b, you'd miss out.

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So what's going on? Two key things, says Fairchild. Firstly, valuable intangible assets such as a firm's brand, or years of investment in research and development, are often understated or even absent from the balance sheet. For example, McDonald's brand is on its balance sheet at around $2bn, whereas brand analysts estimate its value at over $40bn. Secondly, long-term assets such as property are often on the balance sheet at below market value, due to a company's depreciation policies (see below). Buybacks and rising dividend payouts may then exaggerate this issue by taking cash from the balance sheet, shrinking a company's already-understated book value. In effect, you can miss out on otherwise attractive companies because the value of their assets is understated.

What are the lessons for investors? Firstly, if you're investing in individual stocks, then never rely on one valuation metric. It really shouldn't need saying, but even if p/b was entirely without flaw, it would make no sense to look at it in isolation. You need to consider cash flow, profitability, and the sustainability of the business model, among other factors. Secondly, if you're a funds investor, then ensure you know what your funds are investing in if they are following a simple "mechanical" value strategy, then they may not deliver the results you are hoping for.

Finally, be aware that in investing there are very few constants. What worked well in one era or against one economic backdrop may not continue to work. Human behaviour remains largely the same (hence markets are always prone to boom and bust), but regulations and technologies change, and that can have an impact on tried-and-tested valuation measures. Always double-check and test your assumptions, and don't get attached to one methodology.

I wish I knew what depreciation was, but I'm too embarrassed to ask

If you buy a van or a photocopier or any other piece of equipment for your business, then it will wear out as it gets older, and it will eventually need to be replaced. The asset is therefore "depreciating" in value over time. This depreciation needs to be reflected in a company's accounts to allow for the wearing out of any assets in the accounting period.

There are several ways of depreciating the value of an asset. The "straight line" method allows for a fixed amount of the value of the asset to be written off each year. "Reducing balance" depreciation, on the other hand, means that a set percentage of the remaining cost of the asset is written off each year. In each case profits are reduced a bit, and so is the value of the assets on the balance sheet. Note that this is separate from cash flow depreciation does not reflect cash coming in or out of the business, but rather a change in the value of its assets.

Depreciation applies to tangible property, such as machinery and buildings. When applied to intangible assets such as goodwill arising from an acquisition (goodwill effectively represents the excess over and above book value that one company has paid for another in other words, the amount paid for "hidden" assets such as a leading brand) the term used is amortisation.

Depreciation and amortisation policies can sometimes be used to flatter profit figures (or to reduce them for tax-efficiency purposes), which is why it pays to look closely at measures such as cash flow as well as profit before deciding whether to invest in a particular company. It also explains why many analysts use Ebitda earnings before interest, taxes, depreciation and amortisation in their valuation calculations, so as to avoid distortions arising from accounting policies.