New Stock Valuation Method: Price to Book to Price to Tangible Book

Lately we’ve been talking a lot here at the Daily Angle about book value, and for good reason; with the economy down like it is, investors have a (potentially) once-in-a-lifetime opportunity to buy some high quality stocks at bargain prices. One of the metrics value investors have long used for finding undervalued stocks is the price to book ratio.

Conventional wisdom states that a company trading below book value (i.e. a price to book below 1 ) is generally a sign of a bargain stock. However, depending on the source of your information (that is to say, the financial portal from which you are doing your stock screens) the price to book value that you are heeding may be incredibly misleading.

Despite the fact that Benjamin Graham’s monumental Security Analysis defines book value as the sum of all tangible assets, many screeners and finance portals include intangible assets and/or goodwill in their calculations of book value. So common is this practice that, to get to the heart of the matter we have decided to devise a new metric (which is actually an old metric in disguise). We’re calling it Price to Book to Price to Tangible Book to clarify the impetus for the derivation, but really that just works out to tangible book value to book value.

In otherwords, what percentage of total book value is made up by tangible assets? We ran a screen for big(ish) companies with a low (under 1) price to book, then opened up their balance sheet and calculated our own metrics to look further under the hood. (Incidentally, these numbers are coming from manual calculations using the current market cap, rather than book value per share.) Here are three interesting stocks, we found in the screen.

1. Dow Chemical Company (DOW)

View the full PXD chart at Wikinvest

Price to Book: .745

Price to Tangible Book: .970

Price to Book to Price to Tangible Book: .768

To be honest, I was expecting the P/B/P/TB to come out much lower for a company like Dow, whose products have tremendous brand recognition (did you know that styrofoam is a proprietary brand?). I would expect that sort of thing to rack up the intangible assets and goodwill points, but interestingly, it does not. Still, while the difference between a price to book of .734 and a price to tangible book right around 1 is a testament to the strength of DOW’s intangibles (e.g. their brands) a price to tangible book under 1 may be an indication of an overly deflated stock price.

2. Alcoa (AA)

View the full AA chart at Wikinvest

Price to Book: .643

Price to Tangible Book: .971

Price to Book to Price to Tangible Book: .662

The balance sheet lists no intangible assets, but a fair amount of goodwill drags the company’s P/B/P/TB somewhat lower than I expected for a company that does nothing but create industrial grade aluminum. While a price to tangible book below 1 is nothing to scoff at, the value here is not nearly as stark as it initially appears upon first glance at the simple price to book.

3.Pioneer Natural Resources Company (PXD)

View the full PXD chart at Wikinvest

Price to Book: .604

Price to Tangible Book: .663

Price to Book to Price to Tangible Book: .911

Pioneer Natural Resources is a major oil and natural gas drilling company. The P/B/P/TB is an intriguingly high .911, something I wouldn’t have expected even from an oil company. A quick run down their balance sheet indicates no intangible assets whatsoever and very little change in goodwill year over year. Likely, the deflated price can be pegged directly to the financial crisis of October and the resulting plummeting oil prices. That said, the company also has a suspiciously low current ratio (.842) that raises a red flag for a business of this size. If and when oil prices rebound, expect Pioneer to bounce back with them.

Disclosures: none

Comments

[Doe, John:]

Somewhat confused...what was your method for assessing and quantifying the variables you mention (intangibles and goodwill)? Additionally, the portal or screener used is irrelevant: the "tangible book value" is there for your use straight from a company's balance sheet. And as far as I know, neither of the "goodwill and intangibles" extras can end up on a company's balance sheet through GAAP procedures unless acquisition is involved. Total book value should involve no intangibles...that's where market value comes into play.

These figures, in my understanding, are reflected in a market capitalization (and derived stock price) higher than book value (shareholders equity).

Simply put, a market cap lower than shareholders equity (a P/B lower than 1) shows a possibly (and probably) undervalued stock, regardless of intangibles or goodwill. Hence why stocks in general will trade at a value greater than 1: intangibles plus book value.

In all seriousness, unless I'm completely off I'd love further insight into your findings.

Jan 06 03:56 AM

[Tom Armistead:]

Agree with previous commentator, when book value is higher than tangible book value it is normally the result of goodwill from acquisitions. Some companies do large numbers of successful acquisitions, in which case the goodwill is a mark of success: they bought businesses and made money because they never had to recongnize impairments.

In other cases, the goodwill is an impairment waiting to happen: the acquisitions were poorly timed or they overpaid for what they bought.

I think the author is attracted to the concept of assets that are not reflected in book value. One place to look is physical assets that have been depreciated or kept at original cost: meanwhile inflation or increases in replacement cost have increased their value. Some retailers own a lot of real estate, as an example.

Another possibility is R&D expense: GAAP does not permit capitalizing R&D but in some cases R&D creates patents or customer relationships that are extremely valuable. So a company trading around tangible book value that has high R&D expense may have intangible assets that are not reflected on the books at all.

Jan 06 08:22 AM

[The Daily A...:]

Thanks for the comments,

To clarify, first I ran a stock screen for companies with P/B below 1. Then I looked at the balance sheets from those companies and subtracted any line items listed as either "goodwill" or some form of "intangibles" from the "net stockholders equity" value. (For example, on Dow Chemical's most recent 10-Q - tinyurl.com/8opmv2 - under "Other Assets" the company lists both "Goodwill" and "Other Intangible Assets".) I then divided the market cap by this new value to derive my "Price to Tangible Book". The rest of the calculation was relatively straightforward and described in the article.

The idea was get a better look at a company beyond their listed book value which, as you both have pointed out, contains goodwill. I also believe that other "intangible assets" may often be incorrectly valued as their is no necessary intrinsic worth to these numbers.

Let me know if that answers your questions.

On Jan 06 08:22 AM Tom Armistead wrote:

> Agree with previous commentator, when book value is higher than tangible
> book value it is normally the result of goodwill from acquisitions.
> Some companies do large numbers of successful acquisitions, in which
> case the goodwill is a mark of success: they bought businesses and
> made money because they never had to recongnize impairments.
>
> In other cases, the goodwill is an impairment waiting to happen:
> the acquisitions were poorly timed or they overpaid for what they
> bought.
>
> I think the author is attracted to the concept of assets that are
> not reflected in book value. One place to look is physical assets
> that have been depreciated or kept at original cost: meanwhile inflation
> or increases in replacement cost have increased their value. Some
> retailers own a lot of real estate, as an example.
>
> Another possibility is R&D expense: GAAP does not permit capitalizing
> R&D but in some cases R&D creates patents or customer relationships
> that are extremely valuable. So a company trading around tangible
> book value that has high R&D expense may have intangible assets
> that are not reflected on the books at all.

Jan 06 03:06 PM

[ValueInvestor:]

There are many ways company's can inflate their balance sheet and Book Value. Everyone should do a year by year comparison for the last 10 years of any company listing their goodwill, and depreciation. Any significant changes signal possible shady accounting.

Jan 07 03:12 PM