A stock trading below book value can be difficult for value investors to ignore. If a company’s shares are worth only 50 centavos in the market for every peso of shareholders’ equity on its balance sheet, the immediate impression is that investors are buying assets at a substantial discount.
For conglomerates, however, that discount may not always represent a bargain.
This was the subject of a recent Philippine Daily Inquirer article, “Why some conglomerates deserve to trade below book value,” authored by registered financial planner Henry Ong. The study examined 10 holding companies listed on the Philippine Stock Exchange and found that their median price-to-book value, or P/BV, was only about 0.60 times. This means the typical company in the group was trading at around a 40 percent discount to book value.
But the analysis also showed why investors should be careful about interpreting that discount. Of the 10 companies studied, only four emerged as potentially undervalued based on their profitability and required returns.
So why can a company trade substantially below book value and still not be cheap?
Why conglomerates often trade at a discount
A conglomerate is more complicated than a company built around a single business.
One holding company may own businesses across banking, property, infrastructure, food, power and other industries. Each subsidiary can have different growth prospects, profitability and risks. This complexity can make the entire group more difficult for investors to value.
There is also the issue of how capital is allocated.
A highly profitable subsidiary may generate substantial cash, but the parent company decides what happens to that money. It can reinvest the cash in the successful business, distribute it to investors or use it to support another subsidiary that earns much lower returns.
As Ong wrote in the Inquirer article, “A profitable subsidiary may generate substantial cash, but the parent company can reinvest that cash in businesses that earn lower returns.”
This helps explain why investors may be unwilling to value every peso of a conglomerate’s book value at one peso in the stock market.
The conglomerate discount is not unique to the Philippines
The phenomenon has been studied internationally for decades.
The Inquirer article cited a 1995 study by Philip Berger and Eli Ofek published in the Journal of Financial Economics. The researchers found an average value loss of about 13 to 15 percent among diversified U.S. companies. They also found that overinvestment and cross-subsidization among business units contributed to the discount.
But later research provided a more nuanced view.
A study by José Manuel Campa and Simi Kedia, published in the Journal of Finance in 2002, found that diversification itself might not explain the entire discount. After accounting for companies’ decisions to diversify, the estimated discount became smaller and, in some cases, turned into a premium.
The implication for investors is that a conglomerate discount should not automatically be considered either justified or unjustified. Investors still need to examine what the company earns from its capital and the risks they are taking to earn those returns.
ROE helps explain what book value is worth
One way to examine this is through return on equity, or ROE.
ROE measures how much profit a company generates from shareholders’ equity.
Suppose two conglomerates each have ₱100 billion in equity. Company A earns ₱15 billion annually while Company B earns only ₱5 billion. Their book values may be identical, but their earning power is very different.
Company A generates an ROE of 15 percent, while Company B generates only 5 percent. It would therefore be difficult to argue that investors should necessarily pay the same P/BV for both companies.
A company capable of consistently generating high returns from its equity can justify a higher valuation. Conversely, a company that earns relatively low returns may deserve to trade below book value.
This is why P/BV becomes more meaningful when examined together with ROE.
How do we know what P/BV a company deserves?
The Inquirer analysis used a justified P/BV model to estimate the valuation that could be supported by a company’s profitability, growth and required return.
The relationship is expressed as:
Justified P/BV = (ROE − g) / (r − g)
In this formula, ROE represents profitability, g represents long-term growth and r represents the return investors require for taking the risk of owning the stock.
For the 10 Philippine holding companies, the study assumed a long-term growth rate of 6 percent and estimated the required return for each company based on its market risk.
The formula may look technical, but its underlying idea is straightforward.
A company that earns a high return on shareholders’ equity should generally command a higher P/BV. But profitability alone is not enough. Investors must also consider how quickly the business can grow and how much risk they must take to earn those returns.
That is where r, or the required return, becomes especially important.
What is the required return?
Investors do not evaluate a company’s profits in isolation. They also consider the risk involved in earning those profits.
The required return represents the minimum return investors expect to compensate them for taking the risk of owning a stock.
In the analysis, the required return for each conglomerate was estimated using the Capital Asset Pricing Model, or CAPM:
Required Return = Risk-Free Rate + Beta × Equity Risk Premium
The risk-free rate represents the return available from a relatively low-risk investment. The equity risk premium represents the additional return investors demand for owning equities instead of taking that lower-risk return.
Beta adjusts that premium according to the stock’s sensitivity to movements in the overall market. A higher beta generally results in a higher required return, while a lower beta results in a lower required return.
As a result, the 10 companies did not have the same required return even though the same 6 percent long-term growth assumption was applied to all of them.
For example, DMCI Holdings had an estimated required return of about 9.27 percent, while Ayala Corp.’s was about 16.46 percent. GT Capital and JG Summit also had required returns above 15 percent.
Why does required return affect valuation?
Consider two companies that both generate an ROE of 12 percent.
Suppose investors require a 9 percent return from Company A because of its market risk, but they require 15 percent from Company B.
Company A’s 12 percent ROE exceeds the return investors require. Company B’s 12 percent ROE falls below it.
Even though the companies have exactly the same ROE, their economics from an investor’s perspective are very different. Investors would generally be willing to pay more for the company whose profitability compares more favorably with the return they require.
This relationship is captured by the justified P/BV formula.
When the required return rises, the denominator (r − g) becomes larger, which generally reduces justified P/BV, assuming the other variables remain unchanged. In simple terms, the more return investors demand for taking risk, the less they are willing to pay for the same level of profitability and growth.
The model therefore brings together three important considerations:
ROE tells us about profitability. Growth tells us how the business may expand. Required return tells us how much return investors demand for accepting the risk.
Looking at all three gives investors a better basis for judging whether a discount to book value is attractive.
Actual P/BV versus justified P/BV
The next step is to compare the company’s estimated justified P/BV with the valuation investors are actually paying.
If actual P/BV is below justified P/BV, the stock may be potentially undervalued. If actual P/BV is above justified P/BV, it may be potentially overvalued under the assumptions used in the model.
This is a more useful comparison than simply ranking companies according to which one has the lowest P/BV.
A company trading at 0.30 times book value may look cheaper than one trading at 0.80 times. But if the first company’s fundamentals justify only 0.20 times book while the second deserves 1.50 times, the second company may actually offer the larger valuation opportunity.
That is essentially what the analysis found among Philippine conglomerates.
Four conglomerates stood out
Only four of the 10 companies emerged as potentially undervalued under the model: DMCI Holdings, LT Group, San Miguel and Cosco Capital.
DMCI Holdings had the widest difference. Its shares traded at around 0.80 times book value, while its justified P/BV was estimated at 2.09 times.
LT Group traded at 0.60 times compared with a justified 1.40 times. San Miguel traded at 0.50 times versus a justified 0.99 times, while Cosco Capital traded at 0.50 times compared with a justified 0.82 times.
These differences do not mean the stocks should automatically trade at their justified P/BV estimates.
Rather, the comparison indicates that their profitability, assumed growth and required returns produced estimated valuations above where the shares were trading.
For investors, the next step would be to determine whether those companies can sustain their ROEs. If they can, the market discount may prove excessive. If profitability deteriorates, however, their justified valuations could also decline.
Why a 70 percent discount may not be cheap
GT Capital provides perhaps the clearest example of why investors should not simply look for the largest discount.
Its shares traded at only 0.30 times book value. That means the market was valuing every peso of shareholders’ equity at only 30 centavos.
At first glance, a 70 percent discount sounds extremely cheap.
But GT Capital’s justified P/BV was even lower, at around 0.16 times. Under the assumptions used in the model, therefore, the stock’s 0.30 times valuation was actually above its justified level.
JG Summit, Ayala Corp. and Aboitiz Equity Ventures also had actual P/BV ratios above their estimated justified levels, while SM Investments was closer to fair value.
Alliance Global was an exception. Its normalized ROE of about 5.3 percent was below the study’s assumed long-term growth rate of 6 percent, which meant the model could not produce a meaningful justified P/BV under those assumptions.
A discount is only the beginning of the analysis
None of these estimates should be treated as precise fair values.
ROE can rise or fall. Interest rates can change. Investors can demand higher or lower returns as market conditions change. Long-term growth expectations can also change. All of these factors can affect justified P/BV.
The Inquirer article also pointed out that a weaker economy and higher risk premiums could widen conglomerate discounts. Slower earnings growth could reduce normalized ROEs, while greater perceived risk could increase required returns. Both developments would reduce justified P/BV ratios.
For investors, justified P/BV is therefore better used as an analytical tool than as a mechanical buy or sell signal.
A stock trading below book value deserves attention, but the discount itself does not tell investors whether the stock is cheap.
The more useful approach is to ask how much profit the company generates from its equity, how sustainable that profitability is, how fast it can grow and how much return investors should demand for the risk they are taking.
Only then can investors begin to determine whether a conglomerate’s discount to book value represents an opportunity or simply reflects what the business is worth.
