Buying stocks below book value carries a lot of appeal, especially for value investors. Buying into assets for less than they are worth resonates really well with bargain hunters. The potential upside opportunity and margin of safety go up when buying below book, as long as certain conditions are met.
Good Versus Bad Book
If you bought a house in 2006, 2007 or early 2008 you are keenly aware that book value is not all it seems to be. The $400,000 home you thought was a bargain is now being valued for less than $300,000. So the first thing to consider when buying a stock trading below book is to examine the assets that make up book value to see if they hold up. For example, shipping stocks today look cheap on a price to book value basis. DryShips (Nasdaq:DRYS), one of the largest in the industry trades at 0.41 times book. The company's assets consist primarily of shipping vessels which are facing similar devaluations to those seen in the housing market. So, to take the value of those ships at "face" or book value today might not be a great idea.
To be sure, the price of shipping vessels have declined over the past couple of years and shipping companies have taken asset write downs. Book value today is a lot closer to actual book than it was a couple of years ago. But when the majority of shippers in the industry all trade at a 50% or more discount to book, that may be a signaling a red flag. (For related reading, check out Value By The Book.)
A Good Book
On the other hand, a business like Winn Dixie (Nasdaq:WINN) that trades at a P/B ratio of 0.49 might be appealing. Indeed, a grocery store's assets might not inspire much more confidence than those of a shipping company, especially when small fish Winn Dixie is competing with bigger fish like Kroger (NYSE:KR) and Costco (Nasdaq:COST), all of which are competing on price. But consider that the shares trade for $8 and the company has over $3 in net cash per share. So almost 50% of that book is in cold hard cash, which you can value at 100%. The remaining assets - grocery stores and the underlying land, trucks, food - are definitely worth something. By comparison, Kroger, the largest grocer with $8 billion in debt trades for 2.5 times book.
Transocean (NYSE:RIG), the drilling rig contractor branded in the oil spill in the Gulf, trades at about 75% of book value. Oil drilling rigs, the company's principal assets, are extremely valuable and generate tremendous cash flow for the company. It's likely that many of its rigs, especially the ultra-deep water rigs, are actually worth more than stated book due to the strong demand they continue to command in the marketplace. (For related reading, see Five Low Price-To-Book Value Stocks.)
Not An Easy Task
Book value should never be taken at face value, just look at real estate companies today. Nevertheless, with the right company, buying at a discount to book could prove fruitful. (For more, see Book Value: Theory Vs. Reality.)
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