Toyota valuations: kicking the tyres

by SR on August 22, 2012

Toyota share price and price-to-book ratio bands (x)

A vexed question

A few days ago an ex-client had a question about Toyota: “But it is really cheap?”. Valuation being an art rather than a science this is usually a difficult one to answer. My response was that the stock is not as bombed out as it was late in 2011, when the Japanese market itself was cratering and when the floods in Thailand were depressing sentiment on auto stocks still further. At that point, the trailing price-to-book ratio for Toyota edged down below 0.75x, which as the chart above shows, is the lowest level since 2001, including the global financial crisis period.

That would have been a good time to buy but psychologically it would also have been very hard to pull the trigger. Nevertheless, although the share price has recovered to around 0.90x book value per share it is a long way below the median price-to-book ratio of 1.68x from May 2001 to August 2008. So, in that sense, the stock still looks buyable if the company can get back to something like the level of profitability it posted in the 2002-2008 year – after all, it’s the return on those assets that counts.

Although production has recovered nicely, Toyota’s profits and profit margins are still well below the levels of a few years ago. A big part of this is the yen, but I still expect further improvements to filter through over the next couple of years. Year-to-date in 2012 the stock has outperformed the broader Japanese market but I think this can continue for a little while yet, perhaps through to next spring. Toyota might well have longer legs than an auto parts supplier like Denso that has already recovered to something like pre-GFC levels of profitability.

Share price performance of auto OEMs in Japan vs the market

Toyota vs the market

How is Toyota doing relative to the first section of the Tokyo Stock Exchange, that is, the Topix index? If the PB ratio for Toyota has sunk, it might be because investors are generally unwilling to pay historical PB ratios for Japanese stocks. That would be systemic rather than a stock-specific issue. Fortuitously the TSE does release average monthly data for price-to-earnings and price-to-book for the whole of the first section. That PBR can be seen in the chart at the bottom of this post, but we are primarily interested in Toyota’s PB ratio compared to the PB ratio for the market. This is shown in the chart immediately below.

Toyota PB ratio divided by Topix PB ratio

What this chart shows is the monthly price-to-book ratio for Toyota divided by that of Topix first section. It has been has high as 2.0x in the early part of the last decade. Part of that strength might have been investors who were fleeing the dotcom bubble and moving into less volatile stocks like Toyota. The median value of that ratio between Toyota and Topix was 1.5x between May 2001 and August 2008, and recently it has been hovering around 1.3x. While this doesn’t look clearly oversold as it did on the past three occasions in mid-2005, late 2009 and late 2011, it does seem a little lower. I guess the most sensible thing to say is that compared to the market Toyota does not seem to be carrying a premium that could weigh down the share price.

The methodological issue

Another issue to consider is what valuation metric is appropriate. I’ve used many approaches over the past couple of decades, but institutional investors ultimately tend to gravitate to the lowest-common denominator of price-to-earnings ratios (PER) and price-to-book ratios (PBR). This is important: there is no point in using something supposedly sophisticated (like Deutsche’s CROCI or Credit Suisse’s HOLT) in a meeting if the client (a) doesn’t already understand it or (b) they can’t easily reproduce it themselves. Making several hundred adjustments to a company’s historical financial statements and using the result to generate a neat value per share might sound good in business school, but in all likelihood the client sitting across the meeting room table from you regards it as a black box that he sees no reason to trust over less complex approaches.

Even with traditional approaches there’s a wide range of opinion. I remember doing a presentation in one building in Boston and having a fund manager try to tear me apart because I had mentioned price-to-book ratios. It was in the aftermath of the tech bubble in late 2001 and with profits plummeting I felt that investors in tech hardware had no confidence in PE ratios, so I used the more stable PBR instead to try and establish a floor valuation. He didn’t like this. The next client was in a building almost next door, and he was deep value so price-to-book and net assets and so on were very important to him. Two people, both in the same industry, both monitoring the same stocks, both smart, both experienced. Very different viewpoints.

For traditional industrial companies in a volatile industry, I don’t think price-earnings multiples and price-to-book ratios are inappropriate: one just has to use them with care. The key issue for me when looking at Toyota is that the company’s earnings look as if they are finally lifting off the bottom along which it has been bumping since 2008. When earnings are expanding, investors tend to shift away from defensive metrics like PBR and towards earnings-based valuation metrics like PER. We’ll look at that in a future post. What strikes me about the monthly chart below – which is less ‘noisy’ than the daily share price chart at the top of the page – is that Toyota’s price-to-book ratio really is still close to the bottom end of the historical range. We can debate exactly how cheap it is, but clearly expensive it is not.

Toyota monthly price-to-book ratio (x) compared to Topix price-to-book ratio (x)

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