# Price to Book

The price to book ratio is one of the business valuation ratios used to evaluate small cap to DOW Industrial Average stocks. It reflects the market capitalization of a company against the total number of outstanding shares. Common ratios equal anywhere from 1:1 to upwards of 4:1. Higher ratios reflect a tremendous amount of trust and favor by investors due to the company’s long-term stability.

## Value Investing – Setting Buy and Sell Points (Lesson 16)

Setting buy and sell points for any investment security determines the investment’s final return. If the buy is made too early while the security is falling in price, the value investor loses out on not only additional margin upon the sale of that security, but also reduces their margin of safety associated with the intrinsic value point. It is similar on the other side of intrinsic value. If sold too soon, the value investor leaves money on the table. Thus, setting the buy and sell points are important decisions for every investment.

There are tools available to determine these two values. In the simplest of statements, the easiest rule to follow is the Pareto Principle, the old 80/20 rule. This rule basically states that roughly 80% of all outcomes are within 20% of of the value. With security pricing, this principle is simply that 80% of the value change will occur within 20% of the starting point. Thus, if a security’s intrinsic value is \$80, then the probability is that 80% of the maximum change in value will happen within 20% points of the price shift. Therefore, the buy is approximately \$64 and the sell point is \$96. Almost certainly, this rule isn’t pure with security investing. The conception is that if the end results are beyond this 20 percent under and over the intrinsic value point, the value investor must have additional financial support and a lot of history with the security to validate expanding the buy and sell points beyond 20% fluctuation.

This lesson first introduces a basic model to illustrate and reinforce setting the respective buy and sell points. This model emphasizes an important aspect of price change. The angle of change affects the return on the investment. The steeper the price change, the shorter the time period for the change. The shorter the holding period for any investment, the greater the return on the investment. This is illustrated with a chart in this section of the lesson.

## Union Pacific – Buy/Sell Model

Union Pacific’s stock carries the highest price to book ratio among the six Class I Railways. It is about a 1.43 times factor over the next best price to book ratio of CSX at 4.73. Strong price to book ratio investments infrequently have deep or extended price depressions. Therefore, an investor must be patient and wait for opportunities to buy. Take note, Union Pacific’s price to book ratio is 2.33 times that of Kansas City Southern. This means the buy/sell model is also different; it is actually almost the exact opposite of KSU’s model. In KSU’s model, the investor looks for opportunity when the price slips more than 5% and then sells once the stock recovers about 12%. With Union Pacific, the investor gets value by waiting on the price to dramatically decrease. The change must be more than 17% decrease. Gains are earned once the stock recovers almost to the prior peak. This peak to peak model takes much longer to cycle through with high price to book ratio investments, but the reward is worth the wait.

To develop a good model, the reader needs to understand why the down aspect of the cycle is where the real value is earned. Unlike KSU’s model where the down point to buy is 5% less than the peak, with Union Pacific the down point must be greater. In addition, another section explains that buying in a down cycle more than one time is also lucrative to the investor. Finally, the sell point is set and the corresponding results are calculated. The end result is a model that earns a good return for a high price to book ratio investment.

## High Price to Book Ratios – Proper Interpretation and Evaluation

With stock investing, one of the valuation ratios used is the price to book ratio.  It identifies the spread between book value and market value for a share of stock.  As the spread increases the ratio increases.  A good example is Coca-Cola. Its price to book ratio hovers in the 11 range.  Coca-Cola is a Dow Jones Industrial top 30 stock.

## Railroad Stock – Discovering Opportunities

Railroad stocks are solid and steady investments. There is limited downside risk and adequate historical data to illustrate buy and sell points for an investor. If properly applied, an investor should earn yields of 18 to 30% year on year. Learn how to develop the investment model for this particular industry.

One of the benefits of railroad stocks is the downside risk. When the stock’s share price decreases, it is unlikely it will continuously fall. The business ratios used in this industry assist in understanding how far a share price can fall. The further the price decreases, the more lucrative the investment becomes. Thus, the market – other buyer are enticed to purchase the stock due to the desirable attributes of the stock. The first section below covers this particular aspect of the share price decreasing.

On the flip side are increases in share price. How does an investor know when to sell?  If you sell early, you miss out on any additional increases in share price that can add dramatically to your gain upon the sale of the stock. With railroad stock, the historical pattern has rarely wavered from a continuously increasing trend line. The key is to be patient. Yes, the longer it takes to recover and generate gains for the investor, the lower the yield for the investor. Never look at this in isolation, it’s about Bernoulli’s Law (Law of Large Numbers).

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