30 Years of Price to Book - Comstock

Investors will often look at the P/E ratio of the S&P 500 in order to gauge how expensive stocks are. Earnings, the denominator of that equation, are quite volatile, however. In a year like this one, where massive write-downs plague income statements, it is difficult to determine the market's true earning power.

Another method to gauge investor sentiment, though not nearly as popular, is the market's price to book ratio. Unlike earnings, book values are not nearly as volatile (unless of course, you are an over-leveraged bank), and therefore they can give us a decent indicator of how the market is valuing company assets. Courtesy of Comstock Partners, here is the price to book value of the S&P 500 over the last 30 years (original version here):

There are a couple of interesting observations to note in the above chart. First, on a price to book basis, during this recession the market did not fall to the depressed levels seen in the late 1970s. Second, the market's price to book value currently appears to be fairly close to its 30-year average (denoted by the horizontal blue line), despite the fact that the outlook for economic growth appears tepid.

Of course, there are a number of factors that make historical comparisons of price to book values difficult. Accounting methods of how book value is calculated have changed over the years, with an increasing trend towards making book value better reflect market value. Furthermore, there has been a shift when it comes to industries in the S&P 500, with manufacturing companies playing a decreasing role while knowledge-based companies (e.g. software, consulting, other services etc.), where hard-assets are not a determining factor, comprise a larger portion of the index.

For the above reasons, long-term comparisons of historical price to book ratios can be problematic. Nevertheless, investors can look at the price to book ratio over recent periods as a decent gauge of investor sentiment. Clearly, price to book ratios fell dramatically from their 2008 highs, but a large rally has resulted in a recovery of a significant portion of those losses. The above chart won't tell you where the price to book ratio will go, but it will tell you that investor sentiment has recovered to a large extent and that downside risks have increased as a result.

Comments

[wdhalgren:]

Couple of comments. First, using a 30 year chart is somewhat misleading because the insanity of the late 90's pushed price to book well above historical norms, and thus skewed the chart. Also, I'm not sure how Comstock did their calculations, but I'm positive that numerous other sources, including Barron's, reported S&P price to book greater than 6 at some point during the dotcom bubble. The chart above maxes out at 4.9 times.

Second, you make the following statement: "Furthermore, there has been a shift when it comes to industries in the S&P 500, with manufacturing companies playing a decreasing role while knowledge-based companies (e.g. software, consulting, other services etc.), where hard-assets are not a determining factor, comprise a larger portion of the index." It's an often used and somewhat alluring justification for the 30 year bull run in stocks, but may not be completely accurate.

Book value is a measure of the accumulated wealth of a company, whether it was contributed by investors or operating income. From that perspective, valuations have certainly risen above historical norms. The implication of the "soft asset" argument is that human or intellectual capital are now more important than in the past. While that may be true, it does, of course, require that human or intellectual capital of a company be more productive than that of its peers in order to justify a higher price to book. Otherwise, the company has negative intellectual capital which should subtract from valuation. So, an individual company might deserve an elevated price to book based on intellectual/soft capital, but I don't see how it can be true of the market as a whole. Unless this really is Lake Woebegon, and we're all above average.

Oct 16 09:31 AM

[Tom Armistead:]

P/B shoots at a moving target. Book values decreased precipitously at the end of Q4 08 as every company in the index joined in a kitchen sink quarter. Good will from acquisitions? gone. Homebuilders overpaid for land? gone. MBS, CMBS, CDOs, etc? marked to manipulation? Auditors were in CYA mode, they would not sign off on anything that might possibly be marked lower. Deferred Tax Assets? gone. Restructuring? record charges. And so it went.

Anyone who compares Book Values from prior periods to what prevails since the Great Writedown is comparing apples to oranges.

Meanwhile great companies like KO and PG have massive goodwill that was accumulated over decades of successful marketing efforts and it appears nowhere on their balance sheets. Likewise, a lot of assets were marked too low but you can't mark them back up, its against the rules. GAAP's conception of book value is like a ratchet, it only moves in one direction.

Oct 16 01:05 PM

[pslater:]

Saj, a good analysis in all. One observation though; if you overlay long term interest rates over this chart you will see an interesting inverse correlation to the S&P. The very low price/book ratios of the early 80's were accompanied by very high interest rates. I would argue that high interest rates have the same affect on book value (assets) that they do on P/E ratios - they depress them.

If you normalize the price/book ratio for changes in interest rates, I think you'll make a major step toward making this indicator more of a predictive tool. Given the current level of interest rates, I suspect you might find that today's price/book ratio is higher than it should be.

Oct 16 01:24 PM

[bartpr:]

i dont think price to bv has the meaning it had in the past, so i would not rely too heavily on the ratio. with the manufacturing base steadily declining and a lower need for fixed assets the makeup of equity capital and its employment has changed. the number is still equity, but if its employed to develop manufacturing overseas, how does this effect the equation. who knows.

also, with much of the spy 500 as multinationals, and with the protection of foreign earnings from domestic recognition, equity in
a domestic picture is distorted.; maybe a new stardard for equity
should be considered.

i am not an accountant so i could be wrong and foreign equity is picked up as domestic, but i know it is buried in subsidiaries that no
one knows even exist.

perhaps it would be more valid to employ a ratio of market cap to
staff required support current earnings.

Oct 17 08:20 AM

[David Van K...:]

P/B is one of several valuation ratios that can be used. One usually can get a pretty good sense of the valuation of a stock by using several of them in concert: P/B; P/S; P/E (ttm); P/E (forward); PEG; P/FCF. Sometimes the dividend yield is a valuation indicator. Relying on just one or two valuation indicators is potentially very misleading. Instead, use as many perspectives on valuation as you can get.

Oct 18 09:44 PM