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Conclusion

Many investors believe that stocks that trade at a discount on their book values are bargains. Their argument is based upon the belief that the book value of equity represents a more reliable measure of what the equity of the firm is worth or that book value is a measure of liquidation value. The empirical evidence seems to back them since low price-to-book-ratio stocks have historically earned much higher returns than the rest of the market. The peril in this strategy is that book value is an accounting measure and that it may have nothing to do with either the value of the assets that the firm possesses or what it will receive in liquidation from these assets. In particular, accounting decisions on depreciation and whether to capitalize or expense an item can have significant effects on book value, as will decisions on buying back stock or taking restructuring charges.

Looking at the fundamentals that determine value, you should expect firms with high risk, poor growth prospects and negative or low returns on equity to trade at low price-to-book ratios. These firms are not undervalued. As an investor, you should therefore be looking for stocks that trade at low prices relative to their book values without the contaminants of high risk or poor returns on projects. This chapter considered how best to accomplish this by screening low price-to-book stocks for risk exposure and project returns. The resulting portfolio should allow investors much of the upside of a low price-to-book strategy while protecting them from some of the downside.


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