A fortnight ago, we elaborated on four of the seven criteria used in stock selection. In this week's article, we continue with the remaining three criteria: B for Book Value, H for Health and M for Management.
THE book value of a company is an important indicator of a company’s value as it tells us what the owner’s cost of a company is. No owner would be willing to sell a healthy and growing company at below cost unless the company has problems that are not known by general public.
Normally, we use book value per share (total shareholders’ funds divided by the outstanding number of shares of a company) to compare with the current stock price.
Price-to-book ratio is computed by dividing the stock price by a company's book value per share. It gives us the number of times the current stock is selling above or below the book value.
A ratio of lower than one means the current stock price is trading at lower than its book value.
One of the selection criteria is to select stocks with lower price-to-book ratio.
Benjamin Graham in his book entitled Security Analysis said we should consider buying stocks with price-to-book of lower than 1.5x. The number 1.5x or below implies that the maximum price that we pay for a company should not exceed 50% of the owner’s cost.
Due to the implementation of new financial reporting standards, there have been a lot of write-downs and impairment on certain assets of listed companies.
As a result, we can safely say that the current book value of these companies should reflect the owner’s real cost.
The price-to-book ratio is also frequently used in valuing banking, finance and insurance companies. In most instances, it is quite difficult to search for financial institutions that are selling at below their book values. This is because the book value is mostly in cash.
Normally owners would not accept any value that is less than the book value. This explains why most analysts use the price-to-book ratio in valuing financial institutions.
H for Health refers to the financial health of a company. We use debt-to-equity ratio (D/E ratio) to determine the level of borrowings of a company.
It is computed by taking a company's total debts and dividing it by a company's total shareholders’ funds.
A lower ratio implies that the company is using less debt but more equity to fund its operations. Even though cost of borrowing is lower than cost of equity, most investment gurus prefer companies to use less debt.
It will be even better if we are able to find companies that are cash rich and have zero borrowings.
According to Graham, a good company should have a D/E ratio of less than 0.5x. It means that for every RM1 the owner puts into the company, the maximum amount that he should borrow is 50 sen.
The rationale is to look for companies with lower financial risk - lower borrowings mean companies pay less interest expenses and face lower bankruptcy risk.
M for Management refers to companies with high management quality. It is always very difficult to determine the management quality of a company.
Almost all investment gurus, like Graham, Philip Fisher and Warren Buffett say that the management quality is one of the most important factors in stock selection.
A good management should exhibit unquestionable management integrity and try their best to maximise shareholders’ wealth through high dividend payment and capital gains.
It is almost impossible for each listed company to consistently show high profit during all periods, especially in a weak economy.
However, a good management will make sure that they are able to perform better than their peers even in the toughest business environment.
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