Accounting for Book Value

The following article is based on a chapter from Aswath Damodaran's book Investment Fables.

Everyone loves a good bargain! Who doesn't enjoy finding something they wanted on sale? But much like the song of the Sirens, bargains can seduce you into buying things you don't really want or need.

In the same way, investors can be lured into buying "bargain" stocks when they concentrate on only a couple of commonly used valuation tools. The price-to-book ratio (P/B) is one metric that has long been held as the ultimate valuation measure. It's one of the foundational principles of Benjamin Graham's investing philosophy. Graham is largely considered the father of value investing -- a fitting title, since there's plenty of empirical evidence to show how low-P/B stocks generate higher returns than the market.

So what makes the P/B ratio so wonderful? For starters, it's easy to calculate. The price-to-book ratio is simply a stock's market capitalization (stock price times shares outstanding) divided by the book value of equity on its balance sheet. This provides investors with an easy means of comparing the value the market has assigned to a stock with the accounting value of the firm's equity. Stocks that trade at a P/B ratio of less than 1 are considered undervalued.

Proponents of the P/B ratio would argue that this conservative accounting approach to assessing value (book value) is a better measuring stick than the market price (market capitalization), which can often be irrational and volatile. Along these lines, it's commonly believed that a stock's book value equals its liquidation value. If a private equity firm or wealthy investor were to swoop in and buy out a company, they could then turn around and liquidate it by paying off the debt and selling all the assets.

At the time of this writing, there are more than 500 publicly traded companies trading at or below their book value of equity. Here are a few you might recognize.

So why aren't all these companies being taken private and potentially liquidated? Obvious reasons include the costs associated with doing so, and the difficulty of finding a buyer for the assets. But there are even more fundamental reasons, including the potential discrepancy between book value and the actual market value (because of permissive accounting rules), and the risk associated with low-P/B investments.

Deriving book value
To understand book value, we need to start with the balance sheet. The balance sheet shows the value of the assets owned by a firm, and the mix of debt and equity used to finance these assets. The book value of equity represents the original proceeds received when the stock was issued, plus any gains or losses in earnings, less all the dividends that were paid out. It is also the value of the company's assets minus its liabilities.

The accounting view of the value of an asset is based on its historical cost -- the original cost, adjusted upward for improvements made and downward for the loss of value due to wear and aging. Although this system is set up to approximate the asset's market value, firms have some leeway in their accounting, which can create disparity between the book value and market value of assets.

An example of this flexibility is the decision to either capitalize charges on the balance sheet or expense them on the income statement, which does not affect the asset value. Restructuring and other one-time charges can also have a big impact on the book value of equity. Firms' freedom in making these decisions and classifying charges can make the book value a poor indication of an asset's market value.

In the same vein, the book value of liabilities on the balance sheet may be different then their market value due to lack of updating. The debt shown on the balance sheet is valued at the original amount borrowed from banks and bondholders, rather than the market value of the debt. For these reasons, any investment approach based on the P/B ratio will have to grapple with the potential disparity between the stated book value and the actual market value of equity.

Risky business
On top of the risk associated with potential valuation disparity, investing in low-P/B companies exposes investors to greater market risk. As mentioned in one of my previous articles on low price-to-earnings stocks, there are several different ways to measure risk.

In his book Investment Fables, Aswath Damodaran compares low-P/B stocks (defined as stocks with a P/B of less than 0.8) with the rest of the market on three different measures of risk: standard deviation, beta, and debt-to-capital ratio, where capital is defined as the book value of equity plus debt. His analysis showed that as a group, low-P/B stocks exhibit a lower beta (implying less risk) than the rest of the market, but have a higher standard deviation and debt-to-capital ratio.

Standard deviation is a measure of how much a stock fluctuates over time. From a statistical standpoint, it's measured as the square root of a security's volatility. Beta takes this one step further, comparing the volatility of the underlying security with that of the overall market. In essence, it's measuring how changes in the market will affect a stock's price -- the higher the beta, the greater the effect. Investors who hold stocks with higher standard deviations and betas have a greater chance of being "in the red" at some point in time on their investment, which is why some people use these metrics to quantify market risk.

For those who aren't overly concerned about the daily fluctuations of their investments, the higher debt-to-capital ratio of low-P/B stocks is the most disconcerting risk. A high debt-to-capital ratio indicates that a company cannot generate adequate returns on its assets, relying heavily on debt instead. There's nothing wrong with companies taking on debt to reduce their cost of capital. However, the more debt a company takes on, the more leveraged it becomes, adding to its risk of default. Whatever your definition of risk may be, when selecting investments from a pool of low-P/B stocks, it's important to determine whether the potential for excess returns outweighs the additional risk.

It's easy to see why many investors are drawn to stocks that trade below their book value. Still, it's important, as always, to not get tied up in a single metric. Although these types of investments have generated excess returns in the past, it would be small-f foolish for someone to blindly choose a portfolio of low-P/B stocks without first considering the potential valuation disparity caused by accounting procedures, and the additional risk associated with such investments.

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Fool contributor Elliott Orsillo resides near the City of Angels with his wife and his basset hound, Lola. He is a bargain-hunter extraordinaire and holds no positions in any of the companies mentioned above. The Motley Fool has a disclosure policy.