Price to Book Value Ratio

Ichiro Suzuki

Upon rising to the post of Japan Exchange CEO in 2021, Hiromi Yamaji didn’t hide his disaffection with low valuations given to companies listed in the Tokyo Stock Exchange. He was entitled to be unhappy. In aggregate, they traded barely at around their book value.

Low price to book ratio is a product of Corporate Japan’s low return on equity that is attributed to low asset efficiency as well as low profit margins. Over the last few decades, Corporate Japan has accumulated considerable amount of cash on their balance sheets. After the burst of a historic bubble at the beginning of the 1990s, they relentlessly restructured bloated balance sheets, shedding operations that were considered non-core, to be more focused in a rapidly changing world. Restructuring generated a vast amount of cash, and management chose to hoard it. They became stricken to bad memories of difficult times in the 1990s. Banks didn’t help them when their service was most in need, since banks themselves were forced to go through even more fierce restructuring of businesses. They came to learn that they had to help themselves to survive, and piled up cash preparing for rainy days. In the world of stakeholder capitalism, shareholders didn’t speak loudly against excessive amount of cash on balance sheets. Aggressive attempts to take over inefficient companies have been rare. Such an environment allowed management to sit back and run the company not bothered by voice outside the board room. 

Under a low pressure environment on management, Corporate Japan kept delivering rather lackluster performances, which was showcased in the stock market trading not much above their book value. Yamaji pressed them to raise the number. Since the 2010s, the Financial Services Agency has been advocating shareholders value that has been left neglected in Japan. Corporate Japan began to disburse a greater amount of cash in the form of dividends, share buybacks or both. Yamaji’s push accelerated the movement that was already in motion. Management of Corporate Japan have celebrated a newly found joy of watching their share prices rising to new highs, along with higher price to book ratios. The Nikkei index has hit the 45,000 plateau for the first time, eighteen months after having cleared the mark of 38,915 that stood since the end of 1989. 

The Tokyo market today is reportedly trading at 1.7 times its book value. Besides Corporate Japan’s efforts to be more focused on shareholders, rising long-term interest rates have revalued the financial sector dramatically. The sector was the biggest victim of deflation, and their fortune has reversed with the end of it. While CEO Yamaji should be pleased, here’s a catch. The S&P 500 is selling in the north of dizzying 5.0 times book value. While few think the U.S. market is undervalued, its imminent collapse on its own weight might not be seen any time soon, though it could fall sharply in the event of a recession that brings earnings down. 

In the final several years of the 20th century, price to book ratio began to rise markedly, with the advent of the Internet which laid the ground work for the digitally-driven Industrial Revolution. The market heavily rewards enablers of this Industrial Revolution. Their earnings rose exponentially over the years, driving their corporate value to a trillion dollars or considerably higher. With their unmatched competitiveness, these tech titans are thriving beyond the U.S. border. though China has shut itself inside the wall and is operating with their own national champions. This isn’t your grandfather’s S&P500, a Wall Street strategist says.

Before the ascent of the digital economy, price to book ratio for the U.S. was capped at 2.0 times, which made participants expect that the market was set to fall. Under 1.0, on the other hand, the market was considered undervalued, from this perspective. The market was selling below book value in the early 1980s, when BusinessWeek famously ran a cover story “Death of Equity”, after the dismal 1970s. As it turned out, the market was on the eve of a great bull market that ran through the rest of the 20th century, almost uninterrupted. There were a few episodes of severe corrections, the market kept rising over the next forty years. At the turn of the 20th century, newly created tech companies took the baton to lead the market from more traditional corporations. 

In contrast to the U.S., the Japanese economy remains far too manufacturing-centric, still in the mode of the 20th century. Toyota Motor is a great company, exceptionally well managed and profitable, but the market values the company only slightly above its book value. It’s not Toyota’s fault, and the largest company in the market shouldn’t be a car maker. So it’s everyone else’s fault. Failure to spawn superstar digital companies is hurting valuation on Japan that the market is willing to give. On top of Toyota and other car makers that have been underpinning the Japanese economy and industrial strength, there are general trading houses. While being called trading houses, they have evolved into financial power houses that deploy massive amount of capital in what they trade, i.e., mines or oil fields. Amassing their financial power, they have not been known for efficient use of assets. The market gives price to book ratio at around book value at best. Combined capitalization of seven largest trading houses is larger than Toyota. As is the case with car makers, trading houses are a drag on valuation on the Tokyo Stock Exchange, despite their significant contribution to the Japanese economy. 

From the perspective of the stock market, Japan seems structurally flawed. This is still your grandfather’s Nikkei. 

About the author: Mr. Suzuki is a retired banker based in Tokyo, Japan.