Value is a subjective notion that is calculated in many ways. The stock market is often perceived as an infallible forum of liberated capitalism, where the free-market economy dictates the value of the companies trading on it. As such, investors often mistake the value of the company's stock itself as the only value inherent of the company. This inability to differentiate between the market reality and the company's real world reality often stumble those who are unable to reconcile a company's inherent value to its share price. Yet investors would be wise to understand that there are always at least three forms of value being expressed at any given time:
- The value that shareholders are willing to pay on the open market (market cap)
- The value as represented in the cost of its equity (book value)
- The value as a function of its future earning potential (earnings multiple)
Market capitalization is the most easily defined, as a simple function of share price multiplied by the total number of outstanding shares. Yet while the market capitalization accounts for a company's value on the market, it is important to not mistake this for the value of the company from the standpoint of its assets and liabilities. This book value, which is calculated by subtracting the liabilities and intangible assets from the company's total assets, is an expression of the value a company offers were it to be theoretically liquidated today. The income approach captures the value of the company's past or expected future earning potential in relation to price. This is most commonly derived by using the basic P/E ratio, which by measuring the multiple given off of the earnings or expected earnings of a company, allows for standardization in the realm of comparison.
As a result of this, a company can often be thought of as being overvalued in the sense of their market capitalizations if it has a high price-to-book ratio (P/B) and an high price-to-earnings (P/E) ratio, both of which when compared against industry average. It would also be reasonable to believe the opposite is true. A low P/B ratio and low P/E ratio when compared against the industry average are likely indicative of an undervalued company in regards to its share price.
However, it is important to recall though that each approach to value retains its own significance. While it might be likely that a particular share price is either undervalued or overvalued on the basis of these measures, there could be external circumstances that account for this reason to exist the way it does. One common reason for a high P/B and P/E ratio that can justify a higher market capitalization is the anticipation for future growth. Taking the sales growth rate into consideration for these situations would be prudent. Investors would be wise to thoroughly understand a company in order to deduce whether the reason for a high share price when compared against the industry norm is one that rational or not.
The following list of companies qualify for the scenario of having a low P/B and low P/E ratio when compared against the industry average. It is possible that several of these companies are wrongfully trading on the market in an undervalued state. Trailing P/E's were used, all companies had share prices that were trading below their book values, and each had at least $1 billion in market capitalization. All values are taken as of January 25, 2012.
|Company Name||Market Cap.||P/B||Industry P/B||P/E||Industry P/E|
|Arcelor Mittal (NYSE:MT)||$33.1 B||0.56||1.96||9.29||14.8|
|First Solar (NASDAQ:FSLR)||$3.3 B||0.83||3.95||9.24||28.1|
|Royal Caribbean Cruises (NYSE:RCL)||$6.2 B||0.74||4.82||9.94||25.3|
|SK Telecom (NYSE:SKM)||$8.5 B||0.83||3.75||7.18||14.7|
|Guangshen Railway (NYSE:GSH)||$2.6 B||0.65||2.52||9.29||16.6|
|Invesco Mortgage Capital (NYSE:IVR)||$1.8 B||0.94||0.97||4.24||16.2|
|Prudential Financial (NYSE:PRU)||$27.4 B||0.74||1.32||9.06||15.8|