Many times investors try to use the price-to-book metrics when deciding on whether to invest in a particular company. A quick way to look at this is through filtering of the price-to-book ratio. Anything above 1 means you are paying more for what they actually are. Surely we don’t want to pay extra for something worth lesser than what they are.
But how reliable is this metric?
Imagine this scenario.
You have plenty of cash and are ready to hunt for bargain counters which has been trading at low book valuations. You did some basic calculation and are convinced that you are ready to part with your money on this counter. You put all your savings thinking that you are a long term investors and are paying a decent entry price to the counter.
10 years. 20 years. Your hair color has changed and you have grown slightly shorter. The company you owned since those days announced bankruptcy. Oops. All goes the nest eggs you have saved all these years. What has gone wrong?
A value trap is a concept that specify market price which looks inexpensive relative to its intrinsic value, but with hidden agenda. Because investors buy stocks on the assumption that they will one day return to their intrinsic value, they may get stuck on these stocks for a very long time or in the worst case scenario lose completely their capital.
There are many explanations for why a company can be considered a value trap. Below is what I have considered as one of them.
A good deceptive usage of book value would be manufacturing companies who hold plenty of machineries and equipment on their balance sheet. They are part of the PPE portion on the assets segments which are depreciated on a yearly basis. Depending on the treatment of the depreciation method the company is adopting, they usually result in lower book value at the end of the day since these assets are depreciated over time. Even if there is a resale value for these equipments, they usually go down faster than how they would have been depreciated, thus causing a value trap for investors who only rely on the price to book ratio to make decision. To a layman who don’t understanding all of these, think property and car for example. While one can appreciate in value, one depreciates in value. The book value 10 years ago and 10 years later assuming everything else the same will not equal the same since the latter has been depreciated.
On the other hand, a value play is something which is completely the opposite of the former.
If you are cashing in on a value play counter, you usually make a multi-bagger returns for the amount of known unknown risk profile you have taken. Sometimes it may take several years for those value to be unlocked, but you will be handsomely rewarded if you get it right.
Just like the former, there can be many different explanations and justifications for finding a great value play stocks.
One example in finding value play companies is understanding the adoption certain accounting treatment. Take the recently implemented new standards of fair value accounting for Non-Mark to Market Assets treatment for instance.
There are no hard rules for right or wrong investment decision based on any metrics you have. That said, having a better understanding of how a book value is derived would help you think deeper and whether the stock you see at face value fits your investment profile. Filtering is a great tool to help you save time, but they won’t be your life saver when you need them.
Book value hunting is no easier than any other types of investing.