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Academic studies have shown in multiple time frames, in multiple markets, that there is a value effect. Stocks that sell at the deepest discounts to accounting values of their equity, have enjoyed higher returns than stocks that sell at the highest premiums to their equity values. On the basis of overwhelming empirical evidence, the price to book ratio is a useful starting point for value investing.

However, these stocks suffer incredible risks. Many of these stocks are on the verge of bankruptcy, have lagged financial statements which do not accurately portray current equity values, or cannot be rationally valued on the basis of reported financial statements. Since the price-to-book ratio has been connected to long-term returns, is there a long-term measure of risk we can use? Are there methods that can help distinguish value investments from value traps?

One predictive measure of bankruptcy is the Altman Z-Score. This score places companies into three groups: “safe” (Z-score > 2.99), “grey” (Z-score between 2.99 and 1.81), and “distressed*” (Z-score < 1.81), and is surprisingly useful for identifying bankruptcy risk in the coming year. This method of segmenting companyies uses of fundamental (financial statement) data and market capitalization only.** Beyond credit risk prediction, companies with higher Z-scores have been shown to outperform companies with lower Z-scores, in aggregate. One sector has not been accurately modeled: Altman’s Z-score has not accurately predicted the bankruptcy risk of financial companies.

Altman’s Z-score was recently (using financial data reported this year) calculated for dozens of companies with low P/B values and a few other companies as well:

Ticker

Financial Statement Date

Altman Z-Score

P/B Ratio

RAD

5/28/2011

2.34

-0.40

FREE

12/31/2011

0.00

0.07

OTCPK:CASA

1/3/2010

3.09

0.13

TRMD

12/31/2011

0.70

0.13

GMR

3/31/2011

-0.30

0.13

DPTR

3/31/2011

-1.75

0.15

CLNT

3/31/2011

3.48

0.19

USU

6/30/2011

1.36

0.21

HTCH

3/17/2011

1.43

0.22

OTC:PNSN

3/31/2011

-0.86

0.22

CEDC

6/30/2011

0.51

0.22

GIGM

12/31/2011

0.92

0.25

OSG

5/31/2011

1.22

0.27

GASS

12/31/2011

0.43

0.28

TNP

6/30/2011

0.71

0.28

MILL

4/30/2011

0.90

0.29

OTCPK:TBAC

3/31/2011

2.08

0.3

BXG

3/31/2011

2.20

0.3

DRYS

12/31/2010

0.63

0.3

SMSI

6/30/2011

2.82

0.3

BLD

3/31/2011

0.38

0.31

GURE

6/30/2011

4.52

0.32

KEP

12/31/2011

0.55

0.33

SGMA

12/31/2011

2.86

0.34

GTIV

6/30/2011

1.47

0.34

CX

12/31/2010

0.76

0.36

BHO

12/31/2011

0.66

0.37

GEN

3/31/2011

0.15

0.39

IPSU

6/30/2011

1.92

0.39

SPPR

6/30/2011

-0.15

0.41

HKN

6/30/2011

-4.08

0.52

WPCS

12/31/2011

1.81

0.57

DSX

12/31/2010

1.79

0.58

NRG

3/31/2011

1.02

0.64

BKS

4/30/2011

2.27

0.75

LEN

5/31/2011

1.65

0.94

GCI

5/31/2011

3.13

1.02

DHI

3/31/2011

2.29

1.17

KGC

12/31/2011

4.48

1.29

TBUS

6/30/2011

0.30

1.41

PAA

3/31/2011

2.70

1.76

GFI

12/31/2011

2.15

2.0

LLY

12/31/2010

3.55

2.8

UTX

12/31/2010

3.31

2.83

XATA

6/30/2011

0.71

3.69

CHKP

12/31/2011

10.71

3.71

NKE

2/28/2011

7.29

3.98

MCP

3/31/2011

61.03

5.21

PAYX

2/28/2011

2.66

6.26

TSLA

3/31/2011

5.07

6.9

There is only a loose relationship between Altman Z-score and P/B ratio among very low price to book ratio stocks:

[Click to enlarge]
Low Price to Book stocks: P/B Ratio vs. Altman Z-Score
In aggregate, higher P/B ratios are seen for higher Altman Z-score stocks. This is to be expected: stocks with higher valuations ought to be less risky. Since this plot does not line up, the Altman Z-score might be able to adjust accounting equity for risk, enhancing it as a valuation method for stock investing.

*“Distressed” was a label coined by researchers, and should not be taken to mean that any company is bankrupt or in default on the basis of this calculation alone. Credit scoring is not fate, only prediction based on relative past performance of companies grouped by key variables. Time will tell.

**Volatility has be incorporated into a credit scoring model to improve accuracy, but this would reduce the value of a fundamentals-only model for indicating companies for option strategies.

Source: Low Price To Book Stocks: 50 'Risky' Candidates To Consider