The most widely cited valuation metric, the P/E ratio, often doesn't make sense, especially when earnings are under pressure. Book value, on the other hand, is less erratic than earnings. Could book value, then, give us better insight about the index's valuation?
The craziness of P/E
I recently reported that the S&P 500 was on track to trade at GAAP P/E of 4,259 at the end of June -- provided it closed where it did in May, at 919. As it happened, the S&P 500 did exactly that, but the index's GAAP P/E turned out to be "only" 713. Why the big difference?
That 4,259 P/E was based on GAAP earnings per share estimates of $6.17 for the second quarter (and $7.57 GAAP earnings for the first quarter, which was only 97% reported as of the time of writing). The first-quarter GAAP EPS came in at a lower $7.52, but the second-quarter EPS estimate rose to $7.27. Since earnings are very depressed, the net swing of $1.05 was enough to push the P/E way down -- although still so high as to be meaningless.
Can book value save the day?
Valuations based on book value, on the other hand, appear relatively cheap. The S&P 500 is currently trading at 1.7 times book value, against an average P/B of about 2.4 for the past three-plus decades, according to Ned Davis Research.
|
S&P 500 Price-to-Book Ratios |
31.5-Year Average |
Current P/B |
P/B at 2009 Low |
P/B at 2000 High |
|---|---|---|---|---|
|
2.4 |
1.7 |
1.2 |
4.9 |
Copyright 2009 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All rights reserved.
Still, you have to look more closely at how price-to-book ratios behave during economic recessions. Near the lows in March, the S&P 500 traded as low as 1.2 times book value -- the cheapest such multiple in 25 years. But during the recession in 1982, the index traded at a discount to book. By some measures, this recession is deeper -- and may last longer -- than the recession in 1982.
Following the 1982 recession, it took five years for the S&P's P/B ratio to reach the 2.4 mark -- and it only did so briefly before the market crashed, delaying its sustained recovery until the mid-1990s. Given what appears to be a permanent decrease in the availability of credit to support asset prices in the U.S. economy, I don't think anyone should expect price-to-book ratios to return to their historical averages anytime soon.
When book value is fuzzy
Another problem that's especially tricky in today's market is the fact that book values are themselves being called into question. For instance, take a look at the banking sector. Many banks, including Wells Fargo (NYSE:WFC), US Bancorp (NYSE:USB), and State Street (NYSE:STT), are trading at fairly high P/B multiples (at least relative to their peers) of between 1.6 and 1.8.
Meanwhile, several other banks, such as JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), and M&T Bank (NYSE:MTB), trade at or below book value. One extreme case, Citigroup (NYSE:C), has a P/B of just 0.22.
Seeing this, your natural inclination might be to assume that banks that look cheaper on a P/B basis might be less risky than those with higher P/B ratios. But another possible explanation is that investors have more confidence about the quality of assets of some banks over others, and so they're willing to pay a higher P/B multiple for banks with higher-quality assets.
If that's the case, then low-P/B banks might actually pose the greater threat. If toxic assets force further writeoffs, they'll push down book value, proving that investors shouldn't have trusted those artificially low P/B ratios as a sign of good value.
Take book value with a grain of salt
Remember that to some extent, book value is a backward-looking measure. For instance, AIG (NYSE:AIG) sports a book value of nearly $340 per share, but few argue that its shares are undervalued. P/B is only as good as the accounting that determines book value.
Like the P/E ratio, book value is a useful financial metric, but it is only one tool in the security analyst's toolbox. Your due diligence with any stock should never rely on any single valuation metric. Unfortunately, when it comes to security analysis, there is no one perfect measure.
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