In Greek mythology, unsuspecting sailors were lured to their deaths by the sweet, soothing song of the Sirens. Like those unfortunate sailors, many investors today are lured to poor investments in financial stocks by the sweet sound of “available at a discount to book value.” Like Odysseus’s sailors in the Odyssey, investors would do well to protect themselves from the Sirens’ call by understanding some simple concepts.
Primer on Financial Companies and P/B Ratios
Many financial companies, which include banks, insurance companies, and real estate investment trusts (REITs), have seen their stock prices decline recently to below book value for various reasons. Since a financial company’s assets are primarily financial in nature, the book balance for those assets tends to reflect true market value on the balance sheet date. If a financial company’s assets reflect market value, then it stands to reasons that the company’s net book value (assets minus liabilities, or net assets) also reflects market value.
Another way of saying that a stock can be had at a discount to book value is to say that it has a price-to-book (P/B) ratio below 1.0. Conventional wisdom would tell you that when a financial company’s P/B is below 1.0, the company is undervalued because you can buy the company’s net assets for less than market value. In other words, you can buy net assets valued by the market at $100 for less than $100. Sounds like a great deal, right? Well, I think you have to be very careful when applying this “conventional wisdom” because it can result in poor investments.
I have seen articles and analysts touting the large discount to book value as a reason to buy certain companies now. However, I have yet to see a single person comment on the other side of the story. What kinds of return are those assets yielding and would you want to own those assets even at a fraction of book value?
Let’s look at an example.
Example: PMC Trust – REIT
I recently analyzed a REIT called PMC Trust Company (PCC) that was selling for 60% of book value. A REIT is an investment vehicle with special tax advantages that is required to pay out at least 90% of its taxable income to its shareholders each year. PCC primarily originates to small businesses in the hospitality industry collateralized by first liens on the real estate of the related business and often originates loans via the SBA program. PCC only provides 80% of the funding required for non-SBA loans, and 75% of the SBA loans are guaranteed by the federal government via the SBA program. As a result of PCC’s policies, it has retained little risk in its loan portfolio. However, low risk is almost always accompanied with low rates, especially in the current interest rate environment.
The company’s interest bearing assets are priced to yield a relatively low percentage given the fact that there is little retained risk in most of the company’s loans. PCC has partly funded those assets with interest bearing debt. Overall the goal is to have a positive net margin, which is to say that assets have a higher yield than liabilities. And, since the company is actually not very leveraged (less than 1 leverage ratio), the net margin only applies to less than 50% of the assets. The remaining assets are basically pure interest income with no offsetting interest expense to worry about. Of course, there are obviously other operating expenses, but the primary focus is maximizing net interest margin.
Here is the part that most people seem to ignore when mesmerized by the alluring “discount to book value.” Those assets are priced at low yields, and the net book value yields are even lower thanks to expenses. I think it is fair to use return on equity (ROE) as a proxy for that yield, which is about 3% right now. However, the actual yield to the investor depends on the price the investor pays for the stock.
For example, when the stock is trading at a discount to book value of 50%, then the yield to the investor is twice the yield to the company. In other words, the company bought those assets at $1.00 but you get to buy in at $0.50, so you get twice the yield or, using PCC as an example, 6% compared to 3% for the company. If your required rate of return is 6%, then the stock is fairly valued to you. But our required rate of return is closer to 15%, especially considering the risk of further drops in the stock price and the inherent operational risk of a small company. So the company’s ROE would have to be about 7.5% and the P/B would have to still be 0.5 for us to be interested assuming no growth in book value or ROE. When you factor in growth in ROE and P/B as we have done, then it is ok for the current year ROE to be lower as long as it grows and ends up averaging 7.5% over a reasonable time period, assuming that the P/B is 0.5 when you purchase the stock. The higher P/B goes, the higher the average ROE has to be for the stock to be enticing to us, obviously.
So you might say that the current stock price for PCC is fairly priced because it factors in total cost of capital whereas the book value of the company likely only factors in cost of debt and excludes cost of equity (i.e., shareholder expected returns). As a result, in this instance the “discount” to book value is misleading as the yields are so low.
To summarize my point, would you buy at book value a group of income-producing assets yielding 1% that are not free of risk? Probably not when your bank account yields the same rate for much less risk. What if you could buy the assets at half of book value but could not sell the assets? That 1% yield is now doubled to 2% but is still too low. What about 0.10 P/B? Well, now my yield is 10%, so maybe, but it depends on my required rate of return, which is driven by the risk and available opportunities.
Possible Retorts to my Thesis
One possible retort is that we are only considering the income and not the potential for capital appreciation. In other words, I am not considering the fact that the assets I have purchased for 1/2 book value could be bought by someone else at book value, resulting in 100% gain on our investment. Here is the flaw in that argument: it assumes that someone else’s required rate of return is about 3%. You would be better off in a CD or a long-term bond than buying a stock for the 3% yield. I never rely on the chance that others might make poor capital allocation decisions in order for an investment to be worthwhile to me.
Another possible retort is that net book value could grow, which would mean that the company’s ROE can be lower and still possibly be a worthwhile investment. This is basically the concept of compounding interest. If the company starts with $1.00 in net book value and earns 3% on that book value annually without paying dividends, then the actual dollar return will grow annually from $0.03 in year one to $0.031 in year two, then $0.032 in year 3, then $0.033 in year four, etc. Continuing with my example above, if my original investment was to buy those $1.00 of net assets for $0.50, then my yield in year one is 6% ($0.03 return/$0.50 investment), then 6.2% in year two, then 6.4%, etc. Each year, my personal yield on the investment grows. However, since REIT’s must pay our 90% of taxable income annually, it is difficult to grow book value meaningfully, especially if taxable income exceeds book income. In the case of PCC, its net book value has actually declined steadily since peaking in 2004. Although banks and insurance companies can and do realize growth in net book value on a regular basis, they usually have high dividends. As a result, I generally require consistent ROE for banks and insurance companies of at least 10% before I really get enthused about a discount to book value.
Very simply put, discount to book value is meaningless by itself. Understand the historical and expected yield of the net assets you are buying at a discount and compare it to the yield you require from the investment after factoring in the risks of the investment. This simple test should tell you if you are falling into the “discount to book value” trap. Of course, I still advocate conducting significant due diligence and analysis on every investment regardless of how cheap it looks. Only then can you truly value the company. Hopefully understanding these simple concepts will be the beeswax in your ears needed to ignore the Sirens’ call.