Wednesday, September 05, 2007

Are stocks with high price-to-book ratio worth buying?

Reader's Question: Are stocks with high price-to-book ratio (P/B) such as Boeing (NYSE: BA) and Apple (Nasdaq: AAPL) worth buying? Is P/E always more important than P/B? Is there any benchmark for P/E and P/B ratios by sector and industry?

High P/B ratio is often a sign that a business has rosier future prospects than past performance. Share price is high relative to book value because investors have bid up the share price based on expectations of better earnings and/or cash flow ahead.

The quintessential example of a well-known company with high P/B ratio is Amazon (Nasdaq: AMZN), with book value of $550 million at the end of June 2007 and current market capitalization of $35 billion, giving a strikingly high P/B ratio of 64. By the nature of its capital-intensive (to build warehouses and technology) and loss-leader (to win market share) business model, Amazon recorded huge losses throughout most of its corporate history and only in recent years has begun to generate consistent profits. Even some value-oriented investors, such as Bill Miller who manages the Legg Mason Value Trust, have been holding large positions in Amazon's shares for years, looking beyond high P/B and focussing instead on the future earning potential of the company's Internet retailing business.

Boeing (NYSE: BA) currently trades at a P/B ratio of 13, which is quite high. From 1997 through 2005, Boeing's P/B ratio was in the range from about 2.5 to 5.0, more in line with typical stocks in the S&P 500 index. During 2006, due to new FASB rules on pension accounting, the company showed a $6.4 billion reduction in book equity from $11.1 billion to $4.7 billion, which effectively raised its P/B ratio from 6 under the old rules to 15 as reported at year-end 2006. During the first half of 2007, earnings have boosted book value by over a billion dollars to $5.9 billion, giving the current P/B ratio of 13 at a market capitalization of $78 billion. As more retained earnings flow into book value over the years ahead when the much anticipated, super-fuel-efficient Dreamliner 787 goes into production, Boeing's P/B ratio should gradually revert towards the historical range reported prior to the pension-related accounting change.

Apple (Nasdaq: AAPL) is now trading at a P/B of 9, which is the highest P/B ratio the shares have seen during the company's "second wind," post-Mac era. From its nadir of close to parity in 2001 and 2002, Apple's P/B ratio has "risen from the dead," tracking the launch of the company's spectacularly successful iPod in 2001, increased market share of personal computer sales, and summer 2007 launch of its innovative iPhone. Today, many of Apple's price ratios are similar to Microsoft's (Nasdaq: MSFT):

Price-to-Book: 9.3 for Apple vs. 8.7 for Microsoft
Price-to-Sales: 5.5 for Apple vs. 5.3 for Microsoft
PEG Ratio: 1.6 for Apple vs. 1.4 for Microsoft

However, Apple's P/E ratio of 40 is roughly twice Microsoft's 20, and analysts' 5-year earnings growth estimates for Apple are 24%, versus just 11.5% for Microsoft. The upshot is that investors expect Apple's earnings to grow rapidly over the next few years and are willing to pay up for the stock.

In all of the examples cited above--Amazon, Boeing, Apple, Microsoft--the P/B ratios are considerably higher than the market's average P/B ratio of around 3. Importantly, each of these companies has highly successful products and services--Amazon's dominant presence in online retailing, Boeing's lead in airplane production, Apple's popular consumer electronics, and Microsoft's near-monopoly on PC operating system and productivity software. For these companies, sales and profit growth trends and investor expectations about future earnings have pushed valuations to high multiples of book value, so that forward P/E and PEG ratios are generally more useful indicators of value than P/B. (Note: In the extreme value investing world pioneered by the likes of Benjamin Graham, where the focus is on the liquidation value of assets instead of earnings potential, the situation is reversed, with P/B being a better indicator than P/E.)

For a handy reference to compare P/E and P/B (and other ratios) by sector and industry, see the Yahoo's Industry Browser.

(Disclosure: The author does not currently have a position in any of the stocks mentioned in this article.)


Blogger Turley Muller said...

I think you may be interested in a piece I wrote on the same topic. High P/B not always mean overvalued, but then again sometimes it does. Read This:

7:29 PM, September 07, 2007  
Anonymous Anonymous said...

P/B and P/E are two different expressions of the same thing: investor's expectations of earnings growth. The residual income model for stock valuation (which is the DCF model rearranged into a more user friendly formula) explicitly takes into account current book value and shows the value of stock in terms of a discount or premium to book value (based on the present value of abnormal earnings). High growth companies naturally sell at a higher P/B multiple. These same companies will also usually sell at a higher P/E. However, if you have a zero growth company paying all earnings out as dividends, assuming these earnings continue indefinitely, the stock becomes a perpetuity and the P/E will capture this value perfectly, not P/B. If the discount rate is 10%, the stock should sell at 10 times earnings, regardless of its current book value and ROE. P/B for this stock could be lower than one (if the company makes less than 10% ROE) or higher than one (if the company makes more than 10% ROE) and the stock will still be valued appropriately. Personally, for growth companies who pay little if any dividends, I find P/B a more illuminating figure, easier to use, and more conducive to sound investment practices (i.e. with highest attention to the margin of safety shown in part by book value).

12:25 PM, November 25, 2007  
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