With the Dow Jones Industrials (DJINDICES:^DJI) at a new record high, cautious investors are starting to pay attention to valuation more closely than ever on the stocks that interest them. Yet whenever you use simple measures to try to assess whether a stock is cheap or expensive, you need to understand that your conclusions are only as strong as the accuracy of the data. If you rely on numbers that might not be correct, then you could make mistakes in your evaluation of a stock's true value.
Book value is a great example of how financial numbers can be misleading. Let's look at the four cheapest stocks in the Dow in terms of price-to-book ratios and try to assess whether those stocks are actually good values at their current prices.
A valuation that's lighter than aluminum
Among Dow stocks, Alcoa (NYSE:AA) has the cheapest valuation based on price-to-book ratio, with shares fetching just 68% of book value. The aluminum industry overall is in terrible condition, and so peers such as Chinalco also trade at similar levels compared to book value. For its part, Alcoa has had to shutter some of its production facilities recently, strongly suggesting that its plant and equipment items on its balance sheet aren't necessarily producing as much profit as their book value would suggest.
Analysts have argued that Alcoa could get an immediate boost by splitting off some of its more specialty production divisions from its pure mining and smelting operations. Because products like aerospace studs and flat-rolled sheets made of aluminum carry big premiums to the price of raw metal, those divisions arguably deserve higher price-to-book ratios. So far, though, Alcoa hasn't shown any signs of considering such a move, and that stubbornness could be a reasonable basis on which to stay away from the stock.
Are financials finally trustworthy?
The other three Dow stocks trading at relatively low book values are financial stocks. Bank of America (NYSE:BAC) still trades more than 30% below book, while JPMorgan Chase (NYSE:JPM) has just a 5% premium to book value and Travelers (NYSE:TRV) weighs in at about 125% of book value.
For B of A and JPMorgan, the issue for a long time was whether the banks had an accurate view of the value of the assets on their balance sheets. With toxic assets having required huge writedowns during the financial crisis, it took a leap of faith to trust banks' own assessments of their overall book value, as nervous investors kept figuring that additional adjustments would be necessary.
But book value is imperfect even when you ignore clearly erroneous valuations of bank assets. Pure book value includes intangible assets like goodwill, which is a notoriously slippery financial concept that doesn't necessarily translate into real value. Even if you use tangible book value, though, judgment calls like how to value illiquid derivatives and other unusual assets introduce uncertainty into the equation.
Still, JPMorgan and B of A have had so much bad news already come out over the past five years that it seems likely that their financials have largely gotten cleaned out, increasing the chances that their book values more closely reflect reality. That could mean they each have further to rise, although the stocks have already booked some powerful performance recently.
Meanwhile, for Travelers, a price-to-book of 1.25 isn't necessarily all that cheap for an insurance company. With so much of its asset base representing premium reserves that haven't yet gotten paid out in loss claims, Travelers can't afford to get too aggressive with its investment portfolio, and so investors don't give the insurer much of a premium in valuing the stock in comparison to the relatively conservative assets on its balance sheet. Travelers has performed well recently, so it doesn't look like there's as much upside for the insurance giant as there once was.
Don't fall for cheap book values
By itself, book value is only one more measure of a company's value, and like any other valuation method, it has its strengths and weaknesses. By being aware of the pros and cons of book value, you can glean insight about a company without making bad conclusions about its future prospects.
Fool contributor Dan Caplinger owns warrants on Bank of America and JPMorgan Chase. You can follow him on Twitter: @DanCaplinger. The Motley Fool recommends Bank of America and owns shares of Bank of America and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.