Price to earnings (P/E) and price to sales (P/S) are the first ratios that come to an investor’s mind for narrowing down a list of undervalued stocks. However, the price-to-book ratio (P/B ratio), though underrated, is also an easy-to-use valuation tool for identifying low-priced stocks with high-growth prospects.
P/B ratio is calculated as below:
P/B ratio = market capitalization/book value of equity.
What is Book Value?
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 the 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 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 ratio links the P/E ratio to the future growth rate of the company. 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 five of the nine stocks that qualified the screening:
DaVita DVA, a leading provider of dialysis services in the United States, currently has a Zacks Rank #2 and a Value Score of A. It has a 3-5 year EPS growth rate of 21.1%.
MetLife, Inc. MET, a leading financial services company, currently has a Zacks Rank #2 and a Value Score of A. It has a 3-5 year EPS growth rate of 8.4%.
General Motors Company GM, a leading global automotive company, currently has a Zacks Rank #2. It has a 3-5 year EPS growth rate of 8.9% and a Value Score of A.
Hibbett Sports HIBB, a major athletic-inspired retailer, has a projected 3-5 year EPS growth rate of 10.9%. It currently has a Zacks Rank #1 and a Value Score of A.
Canadian Solar CSIQ is a vertically integrated manufacturer of silicon ingots, wafers, cells, solar modules (panels) and custom-designed solar power applications. The stock currently has a Zacks Rank #1. It has a 3-5 year EPS growth rate of 32% and a Value Score of A.