Price-to-book versus price-to-earnings
P/B = price to book value
P/E = price to earnings
At S&C Messina Capital, we are primarily focused on the property and casualty (P&C) insurance industry. Traditionally, the sector is valued at a price-to-book (P/B) ratio rather than price-to-earnings (P/E) ratio, a popular valuation metric commonly used for companies in the S&P 500.
The primary reason for valuing the insurance sector with the P/B ratio in lieu of the P/E ratio has to do with the fact that P&C insurance companies have a lot of assets on their balance sheet. The assets suit as underlying equity to back up their insurance contracts. Similar to an option trader that has a margin requirement, an insurance company needs to have skin in the game in order to underwrite insurance contracts.
As a result, an insurance company is sitting on a lot of cash, not just from the equity that it has to put up, but also from the incoming insurance premiums that the policyholders have paid for the insurance contracts. As there is a lag between when the insurance premiums are paid and insurance claims are paid out, an insurance company holds that money temporarily (booked as a liability for future expected claims). In the insurance world, we call this “insurance float” or “float”. If the annual premiums received are stable or growing, the float can be seen as permanent capital for an insurance company to invest.
The equity and insurance float is generally invested in a diversified portfolio of cash, bonds and stocks. Now, as unrealized gains & losses from its investment activities are not reported in its earnings, an insurance company may be compounding book value at a healthy rate, but that would not be picked up if an investor was only to value the company with a P/E ratio.
As such, one of the metrics used to value an insurance company is the price-to-book ratio.
Valuing an insurance company
An insurance company needs to excel at two things:
As such, investors generally look at how insurance companies navigate through both economic and as well as insurance cycles. The first is a reflection of its investment skill and the ability to manage subsequent downside investment risk that a company is exposed to. The second shows a company’s underwriting capability during soft and hard insurance cycles. Ideally, an insurance company has an “unfair” advantage, such as lower costs than its competitors. Progressive and GEICO are a good example of lowest cost operators, as they market to customers directly versus i.e. AllState which operates through agents, paying them a commission. If an insurance company does not have an advantage, profitability during an insurance cycle depends on management’s discipline to underwrite profitable business at all times. This may lead to a decline in premium volume. Buffett wrote about NICO, his first insurance company, which had no competitive advantage except underwriting discipline:
In order to analyze company’s ability to compound book value through both good and bad economic and insurance cycles, an investor may need to go back a minimum of 10 years. We generally recommend including the Great Recession of 2007-09. As Buffett once said, “You only find out who is swimming naked when the tide goes out.”
Question: Which company would you rather own?
A. A company that is growing its book value at 10% per annum, valued at 1 time book value?
B. A company that earns $10 per annum, bought at 10 times earnings?
How about the current S&P 500 P/E of 25x versus a P/B of 1.5? (July 2017)
Risk / reward
Warren Buffett’s first rule is not to lose money. His second rule is not to forget rule number 1.
By valuing companies at the price-to-book ratio and buying a company’s stock close to, or lower than, 1 time book value, the risk is lowered drastically (provided that the company is not losing money).
We believe Buffett has generally used the rule of buying insurance companies near a P/B value of 1.2x (and selling them at a P/B of 2.0x). Please note that in the current low interest rate environment these numbers may have to be adjusted. Using a P/B multiple provides a floor backed by the assets on the balance sheet. If a company’s P/B multiple drops, there are real assets backing the multiple, so the drop will most likely be mitigated. A drop in stock price for example from 1.5x P/B to 1.0x P/B is a drop of 33%.
In contrast, if one were to buy a company based on its P/E ratio, there is no floor. If earnings are split in half, possibly caused by an economic downturn, a company whose stock price trades on a P/E basis may be halved. The damage could be potentially more if general fear in the market or company-specific fear puts further downward pressure on the company’s P/E ratio.