In the past 50 years, there have been two single ratios that have correlated most with stock market gains. Low P/B ratios and low P/S ratios have done far better than any single one parameter. As James O’Shaughnessy proved in his book What Works on Wall Street, when these single ratios are implemented with various other strategies, the downside risk is greatly reduced while positive gains are more commonly seen. Combine these ratios with the other categories of Investing for Beginners 101 to really see some results. A quick reminder to the 7 parts of this guide is below, you are currently viewing the two factors most correlated to success.
1. Why to Invest?
2. How the Stock Market Works
3. The BEST Stock Strategy and Buying Your First Stock
4. P/E Ratio: How to Calculate the Most Widely Used Valuation
5. P/B, P/S: The Single Two Ratios Most Correlated to Success
6. Cashing In With a Dividend Is a Necessity
7. The Best Way to Avoid Risk, and Putting it all Together!!
Low P/B and P/S Correlated to Success Because They Indicate a Potentially Undervalued Stock
A big reason why these ratios are so successful is because they both indicate if a stock becomes overvalued from the price part. As the P/B and P/S ratios become higher and higher, there are more people buying the stock and driving the price up, making it less valuable to a smart investor. Also, they are more reliable than P/E ratio because revenue and book value fluctuate much less than earnings do. Earnings and earnings per share can be easily manipulated by companies depending on accounting practices. In fact, there have been many instances where companies were caught manipulating their earnings after the fact, and it is more common than people realize. However, sales (revenue) and book value can’t be manipulated and this is another reason why these two ratios are so extremely useful and correlated to success.
Also, think about revenue for a little bit. Revenue is not easily increased or decreased from year to year like earnings is. To increase earnings a company can quickly cut costs by firing workers. Revenue can only be increased through more sales. Or, a company with a successful product may have bad earnings one year because it is using its profits to pay down debt. The P/S would tell the picture that the company is in better shape than the P/E might be telling at that time. A sufficient P/S is anything under 1, with a good one correlated to under 0.8. To calculate P/S, simply divide market cap by revenue.
P/S = market capitalization / revenue
The P/B ratio, compared to the P/E ratio that is only correlated to earnings, is a better way to determine the cheapness of a stock and is utilized in many conservative value investing strategies. The father of value investing Ben Graham popularized the use of P/B ratio and successfully amassed a fortune while teaching countless investors how to do the same.
The Buy Low Strategy
The basic premise behind buying stocks with low P/B ratios involves buying a company who is selling close to or below their book value, with the idea that you are buying a stock with very little downside because it has already been shunned by the market, hence its low P/B ratio. By coupling a low P/B ratio with the limitation of only companies with a strong balance sheet and a stable dividend, you ensure the purchase of great companies trading out of favor in the short term but with great upside potential in the long term. With this strategy, you also prevent overpaying for a company, which further decreases the possible downside. A true buy low, sell high strategy involves ignoring the critics and sifting around for good companies with low P/B ratios.
This strategy has been proven to be correlated to success, as you can see from the following. James O’Shaughnessy extensively researched many fundamental ratios and found that investing in the companies with the 50 lowest P/B ratios over a period of over 40 years would’ve given you the second highest portfolio compared to any other one single variable. When combined with other limitations to reduce risk, a low P/B ratio becomes an integral part of any good value investor’s portfolio.
To calculate P/B ratio, simply divide price by book value. A company’s book value is easily calculated from the consolidated balance sheet, and equals total assets minus total liabilities. Book Value can be seen to be correlated with stability because it measures how much a company’s assets cover their liabilities. To find the consolidated balance sheet, search for it in the company’s 10-k as demonstrated in the How to Calculate P/E Ratio link below. An example of Apple’s ($AAPL) balance sheet is shown below (in millions):
Total Assets = $176,064
Total Liabilities = $57,854
So, book value = $176,064 – $57,854 = $118,210
The price part of the formula comes from the market capitalization, calculated the same way as shown in How to Calculate P/E Ratio. So, again price to book value is calculated like this:
P/B = Market cap/ book value
P/B = Market cap/ (total assets – total liabilities)
For the example, Apple’s market cap is (945,355 shares) * (market price of $452.08) = $427.3 billion. So, their P/B ratio in this case is 427.3/ 118.2 = 3.6 and the stock is therefore still quite a high valuation.
Take a Break, and then Push On!
With 5 of the 7 categories completed at this point in the guide, the information may seem overwhelming and a little intimidating. For those who have made it this far, I must commend you and I know you have what it takes to become a good investor. Really all you need is a desire to educate yourself, and by making it this far you have more than proved this fact. It is the reason why I urge you not to stop here. With only 2 steps left to go, it may be easy to think you’ve learned enough and in it lies a true danger. The danger that you’ve stumbled upon this guide, only to not utilize it to fully benefit yourself.
I urge the reader to take a break at this point if you feel fatigued, and just bookmark the page and continue when you are ready. If you are taking notes and attempting these exercises as we go along, only then will you learn and retain the information.
You must have full attention and feel rested to complete through the rest of this guide and have it benefit you as much it potentially can. So please, take a break and then push on through the rest of the guide. I know it will be worthwhile for you in your quest to long term wealth.