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Posted on 12/16/2016 6:30:00 PM

Asset allocation is the cornerstone to wealth creation over the long term. However, retail investors are unable to implement this simple concept in their portfolios. This inaction is mostly due to the fear caused by volatility.

The mutual fund industry has come up with dynamic asset allocation products to address this. These funds increase or decrease the allocation to equity or debt according to market conditions, thus achieving a sophisticated level of investing in financial assets. The yardsticks to measure the under- or over-valuation of equities is either the price-to-earnings (PE) or the price-to-book value (PB).

Which of the two is a better model? There is no straight answer. But historical trends have shown that PB has an edge over the PE model when it comes to evaluating market valuation.

Where learning matters... It is also not wise to completely overlook the PE model. The PE reflects the present earnings potential of a company and prices fast-growing companies with higher earnings. As a result, one can appropriately price fast-growing companies with high Return on Equity (ROE) which may not have a large asset base (net worth). And herein lies its limitation. The PE model assesses only the present earnings. As one cannot predict the future trajectory of earnings accurately, it has a serious shortcoming when forecasting for the medium to long term.

For instance, since earnings tend to be cyclical, in certain years, robust demand and better realisations may lead to robust growth in earnings. Likewise, at other times, earnings may move down-shift, with profit growth taking a dip into negative territory. In such instances, PEs will exhibit a high degree of fluctuation or sharp spikes.

During a fall in earnings, the average PE multiple of the market will surge, making the market valuation look expensive. By contrast, when earnings growth is at the crest of the cycle, the PE multiple tends to look inexpensive and low, which in turn may present a misleading picture to a novice investor. It might encourage him to enter the market at an inappropriate moment. For instance, in March 2008, the projected Sensex earnings per share (EPS) for 2008-9 was Rs 1,002 while in reality it turned out to be much lower at Rs 820.

The price-to-book-value is a better indicator of market valuation. It irons out, to a large extent, the ups and downs of the economy and the cyclicality of earnings. In essence, it reflects the accumulated earnings of a business, as indicated on its balance sheet. It presents the market price of a company’s assets relative to its book value. That market price could be higher or lower than the book value.

Just as individuals grow their net worth by gradual accumulation of savings over many years, likewise, the objective of any business is to increase their net worth or shareholder wealth by way of generating profits. The profits generated by the company could either accrue to its net worth (these typically are investments in plant and machinery, working capital etc. which enable a company to grow further) or be invested in more growth in net worth at a future time, so that the gains can be distributed to shareholders through dividends.

Hence, in its truest form, the value of a business resides primarily in its net worth or book value, and not in future earnings. This is because there are several uncertainties such as economic conditions, product prices, management change, and so on, associated while gauging future earnings. Book value is created over many years of existence, which is reflected in a company’s net worth, better known as shareholder value.

Earnings are also more volatile than net worth. The PE ratio over a 10-year period has a deviation of about 3.07 while for PB ratio for the same time period works out to be 0.76. These values remained almost the same, between March 2008 and 2009.

Book value is, therefore, a more stable yardstick in order to gauge a company. It does not fluctuate or gyrate due to cyclicality in earnings and looks beyond earnings cycle to help arrive at a fair assessment of business value. As a result, an investor can arrive at a fair value as it does not capture current earnings alone, but more aptly reflects accumulated earnings. Also, this measure is not affected by changing accounting norms as net worth is an accumulation of many years’ profits, and is not influenced by accounting standards.

When the PB tends to fall, it shows that market is undervaluing assets owned by shareholders thereby presenting a fair picture on market valuations. This weeds out the inaccuracies of accessing estimating earnings and provides a much better investor experience if this parameter is used to identify as to when markets are over or undervalued. In short, this parameter refines an investor’s ability to make better investing decisions, leading to better wealth creation in the long run.

Book value has an edge over earnings. Equity funds based on book value have outperformed those focused on earning

This article was published on December 12, 2016 in ET Wealth

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