Evaluating Long Candidates With Price-To-Book Ratios And Altman's Z-Score

Includes: AOL, BG, COCO, CSC, MU, NRG
by: Value Research

Stocks that sell at the deepest discounts below accounting values of their equity (the lowest price-to-book ratios) have enjoyed higher returns than stocks that sell at the highest price-to-book ratios. On the basis of overwhelming empirical evidence, the price-to-book ratio is a useful starting point for long-term value investing.

However, stocks with low price-to-book multiples are vulnerable to tremendous risks. Many of these stocks are on the verge of bankruptcy or are in terrible industries. 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 protect us from value traps?

Two techniques can aid low-price-to-book investors: the use of long-dated call options (LEAPs) to take long positions, reducing the money risked in an individual investment; and the use of the Altman Z-score* to assess the threat of a company going bankrupt.

Altman’s Z-score was recently (using the most recent quarterly financial data) calculated for stocks with low P/B values which also have Jan. 13 call options:

Low P/B Companies with Jan. 13 Call Options




Altman Z-Score

Financial Statement Date


AOL, Inc.





Corinthian Colleges Inc.





Micron Technology Inc.





Bunge Limited





Computer Sciences Corp.





NRG Energy, Inc.




Value investors should consider buying long-dated calls in Micron Technology Inc. or Bunge Limited. Both firms are categorized as “safe” by the Altman Z-score, have long dated call options, and sell at a low price-to-book multiple.

Consider Micron. It sells at $5.50 per share and has a book value of about $8.50 per share. An investor could buy a Jan. 2013 call with a strike price of $2.50 for a cost of $3.40. This allows an investor to have a long position on $6.00 ($8.50 book minus the $2.50 strike) in book value for $3.40, which is a deeper price-to-book ratio of 0.57.

An investor could create a position with a deeper discount by selling a Jan. 13 call with a strike price of $7.50 cents for $0.96. This would sacrifice about a dollar of book value to reduce the cost of the position. ($8.50 is $1.00 above the $7.50 strike price). The overall position would be a call spread which cost $2.44 ($3.50-$0.96) for a book value of $5.00 (the difference of the strike prices), an even deeper price-to-book ratio of 0.29.

A call spread using Jan. 13 expiration calls can also be used to intensify the price-to-book discount for Bunge. BG shares trade for $63.16 and have a book value of about $90 per share. An investor can purchase a $65 strike call for $8.60 and sell a $90 strike call for $1.70. The resulting position would cost $6.90 for $25 in book value, a price-to-book multiple of 0.276.

*One useful predictor 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). Stocks falling into these groupings have historically experience different rates of bankruptcy in the coming year. Note that “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.

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.

This method of segmenting companies uses fundamental (financial statement) data and market capitalization only. 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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.