The Relevance of Price/Book…

Transcript:

Good morning guys and girls. 

Location: The butterfly conservatory inside the Lodhi Gardens

Topic: The relevance of price to book value ratio in financial stocks.

So this is the butterfly conservatory. Let’s see if I find any inside.

It’s a very beautiful location.

Okay. So let’s talk about the relevance of price-to-book-value ratios in valuing financial stocks. And when I say financial stocks, I basically mean lending operations — leveraged companies that borrow money and lend it onwards. Now, before I do that, of course, I want to.talk generally about the relevance of price-to-book ratios and anybody who is a student of value investing and has read books written by Ben Graham would know that the role of book value has diminished over time for all sorts of reasons. One big reason is that a lot of the assets which truly produce outstanding earnings don’t even show up on the balance sheet. So they’re not part of the book value – things like intellectual property, brands and so on.

Another reason is that there is inflation and the real value of assets may actually increase. the replacement costs may increase or their market value might increase. The liquidation value might increase, and that’s not factored into the book value. And the market is factoring that in its evaluation. And therefore the stock, which looks expensive at four times book or five times book, or even ten times book may not be that expensive.

So earnings are predominant factor in the valuation equation, and we all know how the DCF formula works. The value of any asset is a present value of its future cash flows. Now, this is true, by the way, even if people buy assets at a high price-to-book ratio, because they have alternate use for those assets.

So, for example, suppose somebody buys agricultural land from a farmer and pays him, what appears to the farmer to be a very fancy price. Then, the only way the buyer can justify paying that fancy price is that he can convert it into a land which can be built upon for a shopping mall or an office building or an apartment complex.

So, the change of rights on how to use the land, can have a material impact on the valuation. Now, this is obviously known, but what is the relevance of earnings? The relevance is that the fellow who paid a high price for that asset did it because he could extract more earnings out of it. And to get those a earnings, he would have to convert the land from agricultural use to commercial use.

And when he does that conversion, the earning power goes up. What you can earn from that land through agriculture is very little as compared to what you can potentially earn if it was a retail mall, for example. And that’s the thinking. So, even if he pays a really high price-to-book ratio, he’s doing it because he thinks he can extract a lot of earnings though asset conversion. So earnings, or potential earnings, are always in the equation.

Now, I want to specifically talk about situations where the price-to-earnings ratio is low, but the price-to-book value ratio is high, and this applies, by the way, not just to financial stocks, but to any kind of business. So let’s first talk generally and see what happens when price-to-earnings ratio is reasonable. That is, the market value of the business as a percentage of its earnings potential is low. And, when I say low, it means low in relation to AAA bond yields, low in relation to earnings available to investors generally in fixed income and so on.

So the price-to-earnings ratio is low but, on the other hand, the price-to-book value ratio is high. That is, the businesses quoting at a valuation, which is several times the book value of its assets. And, this is a not a very uncommon situation.

How do we interpret this? The role of earnings should be the dominant factor. But what about the role of asset value? Now, it’s important to remember what Ben Graham taught us. And, he was a big believer in asset values. And even though asset values are not that relevant today, but there is at least one aspect of what Graham said, which I think is still relevant today.

He gave an example of a trucking operation. Let’s say a guy has five trucks and he bought them for a total of maybe $200,000. So five trucks bought for $200,000. Now imagine that at this point of time, there is a shortage in the industry and the economy is doing well. Transportation requirements are good and the freight rates are high. Therefore, the earnings of this trucking business are on the high side.

And for a business that has a fixed asset investment of $200,000, you could perhaps earn $50,000 in a year, which is 25% of your investment. That’s an extraordinarily good return, right? I think we all agree with that. So what should this business quote for, in the market? Obviously the market will price it at a premium. It won’t sell for $200,000. It’s illogical for somebody who owns this business to sell it off to somebody else for the valuation of book value. He will ask for a premium over book which is justified. But how much is justified? Two times book? Four times book? Eight times book? Ten times book?

Now, why would that be a crazy valuation for this business? The answer was, as Graham pointed, there are no entry barriers. Anybody can start a trucking business. So here’s we have a situation where if you create a company with five trucks, you put $200,000 in it, and buy five trucks for only $200,000 and you go out and sell the shares of this business in the stock market in an IPO at a $2 million valuation! 

That’s the key question here. Now, Graham cautions us. He doesn’t use the phrase “entry barriers,” but he uses the concept. He says suppose that this trucking business which has all of five trucks which cost $200,000, sells at a crazy valuation of let’s say ten times book. So there’s a $200,000 value of assets and somebody pays $2 million for them.

That’s absurd, right? It shouldn’t happen. And the reason why it shouldn’t happen is something to think about because that’s of relevance to us today. So even when Graham is no longer there, and many of his ideas are outdated, there is a lot of wisdom in some of the ideas.

What is that point that I’m trying to make? The point I’m trying to make is that when there are no entry barriers or there are very low entry barriers, then if the current earnings are good and markets are giving a low multiple for those earnings, which makes the situation attractive to you, then you better beware and think of asset value.

So, in that Grahamian sense, the asset value of $200,000 acts as a sanity check. That’s what it costs to buy these five trucks. And Graham said that in these situations, go with the asset value as fair value. The reasoning is that these earnings, which are high right now, are not durable. They’re not going to last. And the reason why they won’t last is because when people see the opportunity to buy five trucks for $200,000 and sell them in the stock market, through securities, for $2 million, then there will be a huge influx of capital in this industry.

So whenever price-to-book goes too high in a business where entry barriers are very low, you will see a lot of capital entering in that industry. That’s inevitable. So that’s the key point to remember.

Now, let’s apply that in businesses where there are entry barriers when it’s very hard for somebody to get into that business and so the high earnings are actually protected. Now, that’s one situation, which I think you will agree, that a high price-to-book ratio is warranted. The reason is the earnings on book are very good and they are durable. And the reason that those earnings are durable is that nobody else can enter the business or it’s very hard for somebody to enter the business. So very hard for somebody to take away the earning power of these assets. So when you have high earning power on asset ratios and high price to book ratios, then you should disregard the high price to book value ratio as reason to not buy that stock or not buy into that business. And that’s a good lesson.

Now, let’s apply that lesson to financial stocks. Let me do this by talking to you about a specific situation. I’m not going to name the company, but I just want to give it as an example of what I’m trying to say here.

The price-to-earnings ratio of this company at this time is 9x. Post-tax. The return on equity in this money lending operation is an astonishing 29%. NPAs are negligible and not just today, but going back 15, 20 years, as the business has been around for a long time. The price-to-book value ratio, on the other hand, is 3x. And ROA, which is a metric that is used a lot in evaluating lending operations, is an astonishing 5%.

Look at the world around you, you will find a very few businesses in the lending space that have ROAs of 5%.

The capital adequacy ratio is phenomenal at 23% and finally the earnings growth rate of the company over the last several years is about 18% a year.

So, here is a company, which is growing its earnings at 18% a year, has a very safe lending operation for all sorts of reasons that I won’t go into, and this company is selling in the market at a price-to-earnings multiple of 9x. It has a ROE of 29%, but has a price-to-book value ratio of 3x.

And a lot of people who monitor lending businesses are of the view that when valuing such operations, the primary ratio should be price-to-book-value ratio and not price-to-earnings. They would not want to buy this stock because they would think this is a too expensive because its being valued at three times book value.

Now let’s apply the logic of Ben Graham. The price-to-earnings multiple is low, the earnings on assets is high, but price-to-book-value ratio is high. The market value of the equity in business is about three times its book value. And if that’s the case, then just like in the trucking business, will there not be a pressure for people to enter this industry? The answer of course is yes! Who would not want to get into a business by putting a hundred million dollars and floating it immediately for $300 million in the stock market?

So, clearly there is an incentive to put money in industry, but if you look at the history of this particular industry and look at how hard it is to get into the business, maybe you will come to the conclusion — and I’m not saying that you have to come to the conclusion — but maybe you might come to the conclusion that for all sorts of reasons, it’s very hard to take away the earning power of this company. And that it’s very hard for somebody else to do this business. It’s too difficult to do this business and even if someone tries, it will really take a long time for them to hurt this company. In fact, many have tried and have not succeeded in the past. And then there is a huge growth opportunity out there because the niche that this company occupies, has a huge growth potential, because a very large part of the overall industry is still dominated by the unorganized sector. So this trend of shift from unorganized to organized sector — it’s a long-term trend — and it’s nowhere near saturation.

Now, supposing you came to the conclusion that there are reasons to believe that there are  entry barriers over here and that earnings that we see are durable earnings and that they will grow. Then should you not reject the 3x price-to-book-value ratio as a reason to not own the stock?

My answer to that is absolutely yes. Focus on earnings, and not on the book value. You’re really buying earnings. The value of any asset is a present value of future cash flows and cash flows are a derivative of earnings. So the primary factor should always be earnings. And when you bring back those superior earnings to present value, it so happens that the fair value you get results in a warranted high price-to-book-value ratio. So price-to-book value ratio is an outcome of the valuation exercise and not the determining factor in valuation.

When earnings ratios and book value ratios, give the same answer, there is no problem at all. But when earnings multiple tells you that the business is cheap, but the asset ratios tell you the business look expensive, then it becomes a question of entry barriers. Then you have to think about whether the entry barriers are strong or not. And depending upon your answer to the question whether this company’s earnings are durable or not, the spreads are durable or not, the growth rates are durable or not, you will decide whether or not to discard the high price-to-book-value ratio.

If the competitive pressure is going to remain low, then you should discard the high price-to-book a low ratio and go with the low price-to-earnings ratio as the primary factor in thinking about the valuation of the company. 

Just think about this: People who think that this business is cheap if you look at price-to-earnings ratio of 9x, but expensive when look at the price to book ratio of 3x, are also implicitly saying that if there was more book value in this business without any change in earnings, the stock will look more attractive!

The disconnect between low price-to-earnings and high price-to-book can easily be removed by simply doing a thought experiment where you add more capital from the shareholders to the business without creating any more earnings. But you will make it an inferior business if you do that. For example, if you double the net worth of the business, the price to book ratio will collapse from 3x to 1.5x. And now the business, which takes twice the shareholders capital to create the same earnings, will start looking cheap to the guy who’s focusing on the price-to-book-value ratio.

But now this would not longer be a business which has a ROE of 29%. Rather it would be a business which has a ROE of 14.5%. That’s  because now it requires twice the net worth to create the same earnings. But since the earnings won’t change, then at the same market value as before, the price-to-earnings ratio will also not change.

And now you would have a low price-to-earnings ratio and a low price-to-book-value ratio. And the fellow who was earlier rejecting the stock because the price-to-book-value was too high would now be happy to buy it because we just brought it down by mentally doubling the net worth! So, for this person, to make the business attractive in price, shareholders must gift an amount of money equal to its net worth and get back nothing in return. No new shares and no new earnings either.

Now that’s a paradoxical thing. And that’s contradictory. And that’s the point that needs to be highlighted here today. I think you get that. 

And with that, I bring this lecture to an end.

Sanjay Bakshi

October 6, 2020

New Delhi