Here’s a Simple Metric That Can Give Investors an Edge

Now that the major stock market indexes have corrected and the Big Tech wreck has created some rare dip-buying opportunities, it’s time to put together your investment shopping list. To help you pick the best and forget about the rest, there’s a rough-and-ready way to measure a stock’s value as compared to the company’s intrinsic value.

The funny and tragic thing is that very few investors actually pay attention to it. Everybody wants Warren Buffett’s results, but how many people are actually willing to do the deep research that he does? And, who has the guts to buy a stock when analysts are downgrading it and amateur traders are selling it?

In the era of app-based, self-directed trading, people want quick gains with no negative consequences. If the FTX debacle taught us anything, though, it’s that get-rich-quick schemes are illusory and if something seems too good to be true, it probably is.

In the final analysis, nothing can replace the classic strategy of buying and holding a great company at a good price. What’s a good price, though? Does this just mean buying a stock after it has lost 30%, 40%, or 50% of its value?

Let’s not forget about the Buffett-style principle that price is what you pay, but value is what you actually get. Just because a stock has fallen a lot, doesn’t necessarily mean that it offers a good value.

And so, we can use metrics to help us gauge whether an asset is trading at a reasonable price point. You might already know about the price-to-earnings or P/E ratio, and that’s a great one to keep an eye on. There’s also the price-to-sales or P/S ratio, and these are all measures that long-term investors should pay attention to.

Courtesy: Yahoo Finance

Hidden near the bottom of the commonly used valuation metrics listed on Yahoo Finance is the price-to-book or P/B ratio. The one shown above is for Intel or INTC stock.

Here’s how the P/B ratio is calculated. First, you take the dollar value of a company’s total assets, and then you subtract that company’s liabilities. You can find that information on a company’s Form 10-K or annual report, or on the company’s Form 10-Q or quarterly report.

So, if a company has $6 billion worth of assets and $4 in liabilities, then that company would have a book value of $2 billion. Book value really is just a way to quantify a company’s intrinsic, financial worth.

Next, you would take the company’s book value and divide it by the number of outstanding shares (which you should be able to find on Yahoo Finance or Google Finance). Hence, if a company has a $2 billion book value and 100 million outstanding shares, its book value per share would be $20.

The final step would be to take the current share price and divide it by the book value per share (which you just calculated). So, if a company’s stock is trading at $30 and its book value per share is $20, then the P/B ratio would be 1.5.

Courtesy: Business Insider

The graphic shows above sums up the formula for the P/B ratio. Just like it is with the P/E and P/S ratios, the numerator for the P/B ratio is simply the share price of a company’s stock.

Value investors will undoubtedly want a company’s share price (the numerator) to be low, and will want the company’s book value to be high. Therefore, a lower P/B ratio is preferred, though if it’s outlandishly low, this might signal that a company is in real trouble and its share price is heading toward zero.

Strictly speaking, if a company’s P/B ratio is 1, then that company is trading at its book value. However, don’t assume that a company is overvalued if its P/B is above 1. Really, anything below 2 is usually going to be fairly reasonable. When you start getting above 2, it’s starting to look richly valued. Above 3, and you’re probably looking at a stock that’s overpriced, though there are always exceptions and you shouldn’t judge a stock’s value just by one metric.

A P/E ratio below 1 can indicate a good value, but again, be wary if it’s extremely low. In the first graphic shown above, Intel’s P/B ratio of 1.23 is actually quite reasonable. You can see that Intel’s valuation came down to a fairer level due to the Big Tech drawdown that happened this year.

So now, you have a secret valuation tool that’s available to everyone. Feel free to use the P/B ratio – but don’t depend on it completely – to pick out bargain-priced stocks with excellent rebound potential.