Finding Undervalued Stocks

IBM provides a classic example of the effects of lower ROE on PBV ratios. In 1983, IBM had a price that was three times its book value, one of the highest PBV multiples among the Dow 30 stocks at that time. By 1992, the PBV ratio for IBM had declined to one, significantly lower than the average ratio for Dow 30 stocks.

This decline was triggered by a decline in ROE, from 25 per cent in 1983 to about 5 per cent in 1992. In short, we can boil down the determinants of PBV to ROE, earnings growth and risk.

Bringing the various factors together I tried to link these various factors into a formula by running a multiple regression, with PBV as the dependent variable and earnings growth and ROE as independent variables. The PBV, ROE and the earnings growth estimates of all listed companies on the SGX were obtained from Bloomberg.

Because of the dearth of research on many companies and the absence of five-year growth estimates, the results of the regression did not make intuitive sense. It suggested that the higher the earnings growth, the lower the PBV. I used analysts consensus earnings growth forecast next year as growth estimate.

I then dropped earnings growth and tried to establish a relationship between PBV, ROE and risk, using market capitalization as a proxy for risk. This time, the regression line didnt fit well.

Finally, I used beta (a measure of a stock's volatility against that of the market) as a proxy for risk. The results of the multiple regression appeared reasonable. There was negative correlation between beta and PBV. This means the higher the beta, i.e. the higher the risk, the lower the PBV. And the higher the ROE, the higher the PBV.

The R square, or line fit, is 33 per cent. The relationship is this: PBV = 0.318254 + 0.104092 (ROE) - 0.12738 (beta) Using this equation, and an assumed sustainable ROE for each company, I derived a predicted PBV for each company. Multiply that number with the book value per share and I get the predicted share price of the company.

Which are the undervalued stocks?

Based on a conservative ROE of just 6 per cent, the model suggests that Allgreen, CapitaLand and Marco Polo are undervalued, but not by much. But if you think that these companies can earn ROE of more than 6 per cent, then they would be even more undervalued.

Assuming that the assets of Sincere Watch and Hour Glass are of similar quality and both have about the same accounting policies, then it would seem that Sincere Watch is relatively overvalued visa-vis Hour Glass.

Banks and technology companies will have to maintain relatively high ROEs to justify their current prices. F&N appears undervalued when compared with APB Breweries.

Other companies which the model suggests as being significantly undervalued include Hong Leong Singapore, MPH, Raffles Holdings, Ssaagyoag Cement and Singapore Land.

Caveat There are a few advantages of PBV. PBV is an intuitive measure of value which can be compared to the market price. Given consistent accounting standards across firms, PBV ratios can be compared across similar firms for signs of undervaluation or overvaluation. And firms with negative earnings, which cannot be valued using price/earnings ratios, can be evaluated using PBV ratios.

However, we should also be aware of its disadvantages. First, book values, like earnings, are affected by accounting decisions on depreciation and other variables. When accounting policies vary widely across firms, the PBV ratios may not be comparable across firms.

Second, book value may not carry much meaning for service firms that do not have significant fixed assets. It will also tend to undervalue firms with marketable intangible assets such as brand names or patents. This explains why Informatics - a company which is relatively light on tangible assets but has a strong franchise - appears to be vastly overvalued based on the model.

Similarly, companies like SIA (strong brand name), SPH (still enjoying advantages from its monopoly days) and Venture Corp (its skill set in its industry) also show up as being overvalued.

On the whole, the model appears to do a decent job in estimating the undervaluation or overvaluation of brick-and-mortar companies which do not possess any strong intangibles like brand name or patents and operates in a competitive market. Adjustments will have to be made for service companies or those with substantial intellectual properties.