A simple method for finding dirt-cheap stocks

We often want to buy a stock on the cheap – and to do this we need to find how much the company’s shares should be worth. But how do you know if the current share price is too high or too low?

There are many valuation methods around that attempt to calculate the ‘true’ price of a stock – that can assist in determining whether you’re getting ripped off or have stumbled across a real bargain.

One way of finding out how much a company is worth is to consider how much the business would sell for if it went under. If the company was liquidated and all its assets sold, how much would these assets fetch?

Now when a company is liquidated it can only sell assets that people can see and feel, called ‘tangible assets’. Stuff like buildings, land, vehicles, computers, telephones and office chairs as well as financial assets like investments, cash and receivables (amounts owed to the company).

Other assets, like brand name, goodwill, intellectual property, patents, trademarks, copyrights and so forth cannot be easily flogged on the market. When a company is liquidated, intangible assets are pretty much worthless.

Now once the liabilities of the company are paid back to creditors, we are left with what’s commonly termed the ‘book value’ of a stock. It’s what shareholders would get if the company ceased operating immediately.

So in summary, book value is the money that shareholders would receive if the liquidated company flogged all of its assets and handed the money back to them.

To calculate book value you need to grab hold of a company’s balance sheet. Take the total value of the company’s assets and subtract out liabilities (debt) and intangible assets.

Then to work out the book value of an individual share, you simply divide book value by the number of shares on issue.

To get a better handle on this, we’ll put some numbers around it. Let’s say a company has $100 million in assets and $75 million in liabilities. The book value is therefore, $100m less $75 million, or $25 million. So if there are 10 million shares on issue, each share is worth $2.50 ($25 million/$10 million).

One of the masters of value investing Benjamin Graham (the mentor of Warren Buffett) liked to pick up shares in companies whose share price was under its book value.

Is the stock over-valued or under-valued?

A handy measure used to assess whether a company’s share price is justified or not is the Price-To-Book Ratio (P/B ratio). The P/B ratio is calculated by dividing the closing price of the stock by the company’s latest book value per share (from its quarterly or annual statements). Many of you would be familiar with this ratio already, as it’s also commonly referred to as Price/Equity ratio.

The higher the ratio, the bigger the premium the market is willing to pay for the company above its book value. A low ratio means that either the market has got it wrong – and the share price is trading too cheaply – or that the business has little value.

If the P/B ratio is less than one, it theoretically means that the shares are selling for less than the value of the liquidated company’s assets. The company is worth more dead than alive.

Spotting dirt-cheap stocks

Investors like Benjamin Graham preferred low P/B stocks – believing that these stocks had the potential for share price gains in the future.

Sometimes the market unjustifiably punishes a stock and its share price sinks to the bottom of its price chart for a period of time. It’s true that getting onboard at these times can be a profitable strategy and that the P/B ratio can be one way of unearthing undervalued stocks.

The thing to be wary of here is that low P/B stocks can also signal that something is fundamentally wrong with the company – so tread carefully.

Shortcomings of this ratio

The book value metric isn’t foolproof. There are many traps that investors can fall into.

One of the big problems with book value is calculating a reliable figure for total assets on the balance sheet. How do you accurately estimate the value of a 50-year old building, a bunch of ageing computers, or a string of dated company cars?

Book value represents what the company originally paid for the assets, less depreciation for wear and tear.

Assets that are held on the books for a long time might be depreciated to zero, whereas assets that are relatively new might actually be worth more on the balance sheet than if they were sold outright on the market. This can skew book value enormously.

Secondly, this handy ratio isn’t too smart when you are analysing stocks with few tangible assets such as financial services firms, software/internet, technology companies and so on. That’s because the bulk of these company’s assets are in the “intangible” category, meaning that they cannot be touched and seen; items like intellectual property, patents, brand name and goodwill are not included in a company’s ‘book value’. You’ll find that share prices of such stocks will bare little relation to book value.

Book value isn’t a reliable measure for sniffing out companies that are carrying too much debt. Remember that book value is equal to Tangible Assets less Liabilities – so when a company’s liabilities are especially high, the Book Value of the stock will be low, sometimes negative. A low book value means our P/B ratio will be artificially high.

The big plus with the price-to-book value ratio is that it’s a simple valuation method that can employ in your analysis. By combining book value analysis with other valuation tools such as high return on equity (ROE), you’ll be well on your way to spotting real bargains before the rest of the market.