Price to Book Ratio – How to Invest In Stocks

What are price to book ratio?  If you are a value investor, you may want to know as much as you can with two metrics: Price-To-Earnings & Yield.  They are virtually the same, but one si completely upside down from the other.  Nonetheless, getting a grasp on this concept will help you when you pick out stocks for a value investing portfolio.

As I have pointed out two things:

  1. The economy will contract and stocks will move lower because of this; and,
  2. I want to build a portfolio using purely Value Investing techniques & strategies.

I want to optimize my approach as best I can with finding stocks to invest in.  With the leverage of compounding and its ability to really accelerate an investment, I really want to find stocks that will get me to a level in a few years that I can capitalize on long term growth.

While I looked at Price to Earnings just last week, I want to add on to that concept and build in some more information that will be useful.

Price To Book Ratio

Price to Book Ratio allows for someone to look at total equity versus market capitalization.  Here is a breakdown of the stocks I have in the technology sector:

I can easily eliminate any of the stocks that have negative book value, meaning their assets are less than liabilities.  But, price to book ratio is a bit different with comparing one stock to another.  These ratios will allow you to ask questions.

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What is Price-To-Earnings Ratio

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When it comes to value investing and stocks, you will want to know what is price to earnings ratio.  As its name may imply, price to earnings is exactly that: What the price of a stock is relative to how much a company’s earnings are.

The math on this is very simple: You take the share price of a stock and you divide that over the earnings per share of the stock.

It is important to note two things first:

  • Earnings per share would be the total year’s earnings; and,
  • There are a few ways to look at ‘earnings’.

First, when we say earnings, what do we mean?  Earnings could be the previous four quarters; a Trailing 12-Month (TTM), or it could be future earnings.

I believe the stock market will be faltering significantly, so in this exercise I want to use only the previous 12 months.  It is my belief that the economy will contract and businesses are going to see a decline in both revenue and profits.  Therefore, using forward earnings would be difficult because these numbers are not going to hold.

Future & Past Earnings Per Share

That being said, however, you could use either forward or past earnings in an either/or method.  If a value investor looked at past earnings and felt a company was a solid competitor versus other companies, and at the same time would see accelerating earnings in the future, this is a valuable tool to use.

For me, I often start with trailing 12 month earnings (The previous four quarters), and also look forward to the future potential of earnings as a method to look at a stock.

Baseline comparisons

As I mentioned in last week’s post on my portfolio I am researching for, one of the first things you will need to do is establish a baseline for comparison’s sake.

For instance, if you took a look at all (TTM) earnings on the S&P 500, and looked at price, the broader market is approximately 15.

This means, taking price and dividing that over earnings per share (EPS), for all 500 stocks, you get an average of 15.

One of the first criteria that I am searching for is a stock that is undervalued.  So, the first thing I need to look at is for stocks that are trading below 15 on the Price to Earnings basis.

As I showed in the last video, there were some total 620 stocks in the Tech sector that I put together.  Of those, some 300 didn’t even make it to break even with earnings.  They have immediately been deselected.

Next, there are approximately 100 stocks that are below the 15 level. This means, on an average basis, 100 stocks are priced below average.

It is important to understand that this is a model and not a guarantee that just because a stock is below value one day it will be above value the next.

Looking in to the future

Now that I have the basic 100 stocks to look at what is next is to project into the future what the potential earnings will be from any one company.  This will help in determining what future Price:Earnings ratio will be.

I will get into more on that in the future.

What is yield & Price to Book Ratio?

When it comes to value investing and stocks, you will want to know what yield is.  Yield is another metric that is quite literally, the opposite of the first metric: Price:Earnings ratio.

For yield, you are asking what an individual stock would give you in yield at a certain price.  Figuring this out is very simple: You flip the division of price:earnings to earnings:price.

Whereas when you did the division on Price:Earnings you came up with a whole number, with Earnings:Price, you are getting percentage.  This is a yield.  If you were to buy a stock at $100.00, and the earnings were at $5.00, with Price:Earnings, this is a stock that is trading at 20x earnings.

But, on a yield basis, the stock is yielding 5%.

If another stock, trading at $100.00, has an earnings of $10.00 then, this is a 10x Price:Earnings ratio and is said to have a 10% yield.

How to use yield

Yield is a very useful metric because it gives you a sense of the “return on investment” you could potentially receive by investing in a stock.  If you were to buy any of the above referenced stocks, you may want to weigh the future opportunity in owning each of these stocks.

First, I have two mentioned stocks, if you got a yield of 5% or the second mentioned yield of 10%, is either of these good?

The first place we look toward is the price of the US 10-Year bond and its yield. The 10-Year yield gives us an idea of what the market believes is going to be a good yield and, this is a solid benchmark.  For now, the 10-Year yield is just below 3.00% so, any stock yielding more than that should return more than an investment in the US Treasury during the same period of time.

Do you actually get a “yield”

When you invest in a stock, and you measure yield from this stock, are you actually getting this yield?  No.  Not exactly.  What you are getting is participation in the ownership of a company that is receiving a return on its investments in its respective industry.

Comparing Price To Book Ratio & Yield

Which is better?  Neither, truthfully.  Because the math is basically the same thing, both price to earnings and yield are exactly the same thing.  But, price to earnings and yield state the same thing in a different way.

Since the math is the same thing, just flipped, you are not going to glean any information from one number you cannot get from the other.

But, by comparing the price-to-earnings ratio to all other stocks, getting the 15 as a baseline comparison, and by comparing the yield to the 10-year US Treasury, you get another kind of comparison that is useful in different ways.

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