Announced on Jan 26, Tokyo Stock Exchange now targets those Japanese Inc. listed on Prime market with PBR below 1 to disclose their improvement plan regarding to their cost of capital management. In the past, I’ve ever heard one of the fund managers mentioned that Japanese stock market has more value stocks compared to other global market when using several fundamental metrics screening. In fact, according to one survey, it is pointed out that the stocks with PBR below 1 is less than 5% in US, less than 20% in Europe, but around 40% in Japanese stock market.

So, if the Tokyo Stock Exchange successfully changes those stubborn Japanese Inc., I believe the nikkei225 or TOPIX indices may have some upside potentials, just like how Japan implemented corporate governance code and investor stewardship code in the past.

Although many investors classify low PBR as an indicator of value stock, those PBR below 1 is not necessary meaning the stock is undervalued. Rather, in financial theory, those stocks with PBR below 1 could be possible an indicator that the company is not earning economic profit or value-added profit. This comes into the basis of residual income model.

Say for a very simple example, in 31 Dec 2021, a company with total equity RM 1 mil listed on stock market with IPO price RM 1 per share (PBR = 1.00; no. of listed shares = 1 mil ). In 31 Dec 2022, the company earned an accounting profit of EPS at RM 0.60 and distributed out all as dividends. Assume in the zero growth circumstance and cost of equity is 8%, indeed the company must earn an economic profit at least EPS 0.80 to cover its 8% cost of capital. In this case, since the company is earning below the economic profit of -0.20 (=0.60 – 0.80), the stock price should declined to RM 0.80 from the IPO price of RM 1.00. Hence, in the end of Dec 2022, the PBR should be traded as 0.8 multiple (= 0.8/1.00) below its book value per share.

The main point is the cost of equity. However, accurately measuring the cost of equity is not an easy task. No matter using CAPM model or building-up model, cost of equity is more likely result in a range and different for each investor. Some stocks could have very low cost of equity for a long horizon, in the opposite, some stocks could have a very high cost of equity for any unknown reasons. At certain point, it is also subjected to stock market sentiment in short-term.

Furthermore, most of the companies with foreign operation has FX translation adjustments, or the financial assets classified as FVOCI, and defined benefit pension reserve on their book value of equity, so investors are not easy to estimate the true economic profit from accounting data.

Despite any drawbacks on this, the fact is PBR below 1 does not mean cheap or undervalued, rather a signal for the company management to take care on their cost of capital management.

Original published on:

​https://streetanalystblog.wordpress.com/2023/01/30/pbr-below-1-does-not-mean-cheap/​