The Indian market has rallied about 50 percent from the lows recorded in March 2020. After a sharp rise, investors are now looking to add stocks that are trading at attractive valuations.
One of the ways to identify a company based on its value is Price-to-Book ratio which in simple terms measures the market value of a company relative to its book value.
P/B is a good tool to do bottom fishing when there is a very sharp correction in either the index or a company’s stock price as when there is a threat to earnings in the short term, P/E looks expensive which can be misleading, suggest experts.
We have shortlisted some stocks based on price-to-book value multiple from the BSE 500 stocks. There are as many as 18 stocks that are trading below P/B of less than 1, including Dish TV, Canara Bank, Union Bank of India, Bank of India, BHEL, Mahindra Lifespace, Indiabulls Real Estate and UCO Bank.
Note: The data is for reference only and not buy or sell recommendations. It is purely for research purposes.
Clearly many companies look undervalued but the real question is should one consider investing in these companies or are they value traps?
Let’s understand what is a value trap? The maximum number of stocks that look cheap on valuations could turn out to be a value trap. Investors should deep dive into companies that are trading at cheap valuations, and avoid those with bleak future and having very poor growth visibility, suggest experts.
“Companies threatened with substitute products or technology disruption could also become future value traps. Companies whose RoE is consistently remaining below the weighted average cost of capital is also a value trap,” Rusmik Oza, Executive Vice President, Head of Fundamental Research at Kotak Securities told Moneycontrol.
From the list, particularly for PSU banks, many of them are trading below 1x on P/B but there is a reason for it. “Weak balance sheet, rising NPAs, lower capital adequacy ratio and the threat of erosion in net worth are some of the reasons for few banks to trade below book value,” said Oza.
In most of the other non-banking stocks which are trading below 1x P/B, there are multiple reasons. Few of them are loss-making with very little probability of reattaining profitability.
Oza further added that a few other companies that are trading below 1x P/B don’t have any visibility of growth. Their revenues are either stagnant or falling with erosion in margins and poor RoEs. Most of these companies are clearly a value trap.
How to avoid value traps?
In India, only growing companies thrive and deliver good returns. One should use P/B in only certain businesses like real estate, utilities, banks, and NBFCs.
In certain hardcore asset-based businesses like cement, steel, hotels etc. when the cycle is extremely negative and stock prices have been beaten down disproportionately then P/B should be considered to value the company, says Oza.
Whether a company is a “value trap” or is a great investment opportunity and is available at a “discount to intrinsic value” it requires much more study than just looking at this ratio.
“Value traps are companies that appear as if they are cheap but are actually not cheap. These companies are, in fact, more expensive on their total value, i.e “debt + market cap” basis,” Dr Vikas Gupta, CEO & Chief Investment Strategist at OmniScience Capital told Moneycontrol.
“Consider buying a house on loan for Rs 1 crore. There is a down payment of Rs 20 lakhs which is equivalent to the market cap and there is the loan component of Rs 80 lakhs. If one only looks at Rs 20 lakhs of equity component and decides that the house is cheap, it could be a value trap. The actual price of the house is Rs 1 crore,” he said.
Gupta further added that the easiest way to avoid a value trap is to avoid all high-debt companies and loss-making companies.
Rusmik Oza of Kotak Securities advises investors to avoid companies with bleak future and the ones which have very poor growth visibility. “Companies threatened with substitute products or technology disruption could also become future value traps,” he said.
He further added that companies whose RoE is consistently remaining below the weighted average cost of capital are also a value trap. Such companies will never be able to generate wealth for investors.
“Ideally one should look at companies generating higher cash flows from operations, having lower debt/equity ratio, having decent margin profile, and whose product has a longer shelf life,” he added.Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.