Friday, February 14, 2014

Bullshit financial theories part 3: Industry price/book ratio

Hi guys, check out the graphic at the top of my blog. Fucking badass, huh? To channel Rainbow Dash from My Little Pony, the graphic makes my blog at least 20% cooler.  Anyway, in part 3 of the bullshit financial theories series, I look into how some analysts go full retard when they base their recommendations on the industry price/book value ratio.

First of all, I don’t think the price/book ratio should be used to determine if a company is overvalued or undervalued. Future owners’ earnings discounted back to the present should be used to judge whether or not a company is likely to be a good investment. A company with a price/book ratio of 0.5 is still a shit investment if it is capital intensive and has to reinvest most of its cash flow in plant & equipment. Some people might argue that the company can always liquidate its assets and pay a dividend or invest in a more attractive industry. But unless you’re ultra-rich, chances are that management won’t give a flying fuck about your suggestions to liquidate assets. Even if the company did liquidate its assets, it may not sell them for as much as their reported value.

Banks are a bit different as the reported value of assets such as loans & marketable securities are more objective than the reported value of buildings & equipment. But even with banks, the price/book ratio has limited utility. I guess that a bank is probably undervalued if its price/book ratio is below 1 or slightly above 1. But other than in very obvious situations, the price/book ratio doesn’t tell me much.

I think that analysts that recommend a bank mainly because its price/book ratio is lower than its peers should take their fancy degrees, shred it, put it in their pipes and smoke it.  Just because a bank has a lower price/book ratio than its peers doesn’t mean it will make a better investment. The bank could deserve the lower price/book ratio as it may have a significantly higher cost of funds, is terrible at managing credit risk or etc. And just because a bank has a lower price/book ratio than its peers doesn’t mean it’s undervalued, the bank could be overvalued and its peers could be even more overvalued. While I didn’t make it to the dean’s list, I think it’s a mistake to invest in something that’s overvalued, even if it’s less overvalued than its peers.

Well, I guess I will conclude the article here. I’m currently working on the performance report of the Greedy Dragon portfolio. I should be able to publish it by this weekend, so please check back then if you’re interested. As always, thank you for reading. Take care and stay rational.

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