Problems with price/book

9/1/2008


Historically, the price/book ratio — stock-market value divided by shareholders equity — has proved useful for valuing financial companies. But turmoil in the sector has rendered the metric ineffective in recent months.

In rolling 12-month periods since December 1994, the one-fifth of financial stocks in the S&P 500 Index with the lowest price/book ratios outperformed the average financial stock in the index by an average of 1.7%. But the stocks with the lowest P/B have lagged in the last 12 periods, often by a large margin. Before that streak of weak results, the quintile with the lowest P/B had outperformed by an average of 2.6% since 1994.

Why has price/book lost its predictive power in recent months? Blame the credit meltdown. While the total stock-market value of financials in the S&P 500 Index fell 35% in the 12 months ended July, the book value of those stocks declined just 3%. Price/book ratios fell, making stocks look cheaper. At the end of July, the sector’s P/B ratio had dipped to 1.41, the lowest point since December 1994. But widespread problems with mortgage-backed securities and problem loans suggest book values will drop further as financial companies take more write-downs.

America’s largest financial companies have written off several hundred billion dollars in debt securities and problem loans over the last year, but the massacre could be far from over. It will take months, perhaps more than a year, before Wall Street can assess the true decline in the value of many debt investments. The stock market looks forward, and the prices of financial stocks suggest Wall Street expects more bad news.

While price/book doesn’t have the predictive power it once did, the use of a second statistic in concert with the ratio boosts returns. The top one-fifth of S&P 500 financials based on both price/book and Quadrix® Overall score outperformed the average financial stock in the index by an average of 2.3%, well above the 1.7% outperformance of the P/B ratio alone. The benefits of adding a second statistic are even more striking in the S&P 1500 Index of large, medium-size, and small stocks.

Overall, the financials don’t look good. Reflecting a paucity of appealing options, the Forecasts currently recommends only three financials as Long-Term Buys — Aflac ($54; NYSE: AFL), MetLife ($52; NYSE: MET), and Wells Fargo ($29; NYSE: WFC) — and none as Buys. All three of our recommended stocks have outperformed the S&P 500 Financial Sector Index over the last three years, as shown at left.

MetLife, with a price/book ratio of 1.1 and a Quadrix Value score of 94, is a diversified insurer that seems capable of topping Wall Street expectations of a 7% decline in per-share profits this year. Aflac, a provider of supplemental life and health insurance, has excellent growth potential. Consensus estimates project per-share-profit growth of 22% this year and at least 13% in each of the next two years. Wells Fargo’s conservative approach to lending has kept its balance sheet stronger than those of most peers.


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