Here's the latest in our series of killer equities interview questions sent in by members of the giant eFinancialCareers community. This was allegedly asked for an equity research role at Deutsche.
THE QUESTION: Why might a stock trade below its book value and should we always buy those stocks? Can you think of any examples right now?
Since book value is an accounting term, there are various reasons why this may happen.
This situation can arise because of the way the assets are accounted for on the balance sheet. But it can also happen for very negative reasons. For example, the solvency of the organization might be in doubt, or the structural future prospects of the industry the firm is in might be bleak.
The quality of the assets and earning potential of the given firm must always be taken into account when buying stocks with low book values. Just because the price to book multiple is less than one, there is no guarantee that the stock price will rise.
At the time my friend was asked this, there were very few obvious groups of stocks trading below book value. This made the question difficult to answer. At present, however, there are plenty of obvious examples - particularly in the Japanese stock market.
The problems in Japan are primarily because the outlook for the economy is very poor given the high debt levels, declining savings rates and poor demographics. Even before the recent earthquake, something like 2/3 of the Nikkei 225 stocks were trading below book value.