Sunday, 24 June 2012

Puzzling Valuations: Price-to-Book

When I last left off, we looked at PE ratios and the forward 12-month return on the Singapore market.

The general conclusion there is lower PE ratios tend to correspond with higher returns, and higher PE ratios tend to correspond with modest (but still positive) returns. While not entirely discounting the buy-low-sell-high (BLSH) principle, it’s not exactly a full endorsement, since apparently you can still buy high, and make a decent ~10% return.

So I figure we can try a different valuation metric - price to book ratio (PB).

The PB ratios compares price to the book value of the company. Book value measures tangible assets, i.e. all measurable, quantifiable assets. So PB says how much you’re paying for all the measurable assets in a company. (As opposed to PE that tells you how much you’re paying for the earnings of a company).

So over the same period (end-2008 to end-April 2012) I’ve plotted 12mth fwd returns, against the index-adjusted PB ratio of the STI.
The relationship seems similar – low PBs correspond with higher returns, which higher PBs correspond to lower returns. Historical data says PB of ~ 1.8X is a sign that 12months later, returns are likely to be negative. On the flipside, historical data says PB of ~1.2X is a sign that 12months later, you’ll see pretty good returns. Sorting the PB ratios in ascending order gives a clearer picture the relationship.
Sorted PB ratios make a clearer case for the BLSH approach. Up to 1.4X and even 1.5X PB ratios, historical data says you can still see positive returns if you take a 12-month position in the market. Somewhere around 1.6X your returns are far less certain. And no good has ever followed getting in ~1.8X.

By now, you can tell this is pretty simplistic analysis. Most professionals armed with Bloomberg terminals can pull this data instantly and slice, dice and triple splice it like a samurai.

My own efforts are more suited to wielding a butter knife…less chance of me cutting myself, which I do fairly frequently.

There is one more way I want to spread the data - by varying the holding period. But that’s some number crunching I’ll save for next week.

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