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How important is Book Value?

A reader questions us on how important Book Value is when evaluating a fund. It is a tool for comparison and can be used in conjunction with other parameters

I find that for evaluating an MF scheme, you take into account the net asset value (NAV) which is based on the market price of the stocks held by the fund. You do not take into account the book value of the portfolio. Is there any significance of book value in evaluating performance of the fund manager? Can this be used as an indicator for buying or selling a fund.
-Rajinder Singh Nibber

We do use the book value in the form of price to book value ratio (PB) which compares a stock's market value to its book value (book value is assets minus liabilities). A lower PB could mean that a company's stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. A fund's PB is calculated on similar lines as the PE (price-earning ratio), i.e. the weighted average PB of all the stocks in the fund's portfolio.

Just the way standalone NAV is not used in evaluating a fund, similarly stand alone PB signifies nothing. Nonetheless, a fund's PE and PB can be used for comparing funds in its category, or in comparing categories. One way of comparing funds is to use each fund's PE, PB and market capitalisation to differentiate between funds. However this can be a cumbersome task which in all probability will not yield any definite results. The Value Research Style Box takes care of this problem by presenting a unified snapshot of how a fund's portfolio looks relative to others in its category. This snapshot is a nine-grid matrix, which represents an equity fund in terms of its market capitalisation and valuation.

The style box tells you whether the fund's focus is on growth or value-oriented stocks or a combination of both (which we call blend). In the growth investing style, the fund manager scouts for companies with potential of growing faster than others. This optimism is reflected in the premium valuations commanded by these companies' market price. On the other hand, a value investor buys into stocks, which are undervalued and have the hidden potential for turning around but are usually ignored by the market. Growth stocks typically have above average PE ratio and PB value ratios (PB). In contrast, value stocks have low PEs and PBs. Growth stocks do well during periods of rapid economic expansion, while value stocks typically perform well during market downturns or in the initial stages of market recovery. A fund, which follows growth investing, will lie on the left column of the matrix and a value investing fund would appear on the right column.

The combination of these measures represents the fund's style in terms of market cap and growth potential, through nine possible combinations. However given that the PB is an average, there will be stocks in the portfolio of funds which will not strictly adhere to growth or value stocks.


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