What price should you pay for a company's shares? If the goal is to unearth high-growth companies selling at low-growth prices, the price-to-book ratio (P/B) offers investors a handy, albeit crude, approach to finding undervalued treasures. It is, however, important to understand exactly what the ratio can tell you and when it may not be an appropriate measurement tool.
Difficulties in Determining Value
If you identify a company with strong profits and solid growth prospects, how much should you pay for it? Investors might use discounted cash flow analysis (DCF) to find the fair value for the stock, but DCF can be complex, even if you can manage the math. The calculation requires an accurate estimate of future cash flows, but it can be awfully hard to look more than a year or two into the future. DCF also demands the return required by investors on a given stock, another number that is difficult to produce accurately.
What Is Price-To-Book Ratio?
What Is the Price-to-Book Ratio (P/B)?
There is an easier way to gauge value. Price-to-book value (P/B) is the ratio of market value of a company's shares (share price) over its book value of equity. The book value of equity, in turn, is the value of a company's assets expressed on the balance sheet. This number is defined as the difference between the book value of assets and the book value of liabilities.
The equation appears as follows: Price-to-book ratio=total assets−liabilitiesstock price
Assume a company has $100 million in assets on the balance sheet and $75 million in liabilities. The book value of that company would be $25 million (100 - 75). If there are 10 million shares outstanding, each share would represent $2.50 of book value. If each share sells on the market at $5, then the P/B ratio would be 2 (5 ÷ 2.50).
What Does the Price-to-Book (P/B) Ratio Tell Us?
A P/B ratio analysis is an important part of an overall value investing approach. Such an approach assumes that the market is inefficient and, at any given time, there are firms trading for significantly less than their actual worth. For the P/B ratio, lower values, particularly those below 1, are a signal to investors that a stock may be undervalued.
For value investors, the P/B ratio is a tried and true method for finding low-priced stocks that the market has neglected. If a company is trading for less than its book value (or has a P/B less than one),investors assume one of two things: Either the market believes the asset value is overstated, or the company is earning a very poor (even negative) return on its assets.
If the former is true, then investors are should reject the company's shares because there is a chance that asset value will face a downward correction by the market leaving investors with negative returns. If the latter is true, there is a chance that new management or new business conditions will prompt a turnaround in prospects and give strong positive returns. Even if this does not happen, a company trading at less than book value can be broken up for its asset value, earning shareholders a profit.
A company with a high share price relative to its asset value, on the other hand, is likely to be one that has been earning a high return on its assets. Any additional good news may already be accounted for in the price.
Moreover, P/B provides a valuable reality check for investors seeking growth at a reasonable price. P/B is often looked at in conjunction with return on equity (ROE), a reliable growth indicator. Large discrepancies between P/B and ROE are often a red flag. Overvalued growth stocks frequently show a combination of low ROE and high P/B ratios. If a company's ROE is growing, its P/B ratio should be doing the same.
The Weaknesses of the P/B Ratio
Despite its simplicity, P/B has its weaknesses. First of all, the ratio is really only useful when applied to capital-intensive businesses, such as energy or transportation firms, large manufacturing concerns, or financial businesses with plenty of assets on the books. Thanks to conservative accounting rules, book value completely ignores intangible assets such as brand name, goodwill, patents and other intellectual property created by a company. Book value does not carry much meaning for service-based firms with few tangible assets. For example, the bulk of Microsoft's asset value is determined by its intellectual property rather than its physical property; its shares have rarely sold for less than ten times book value. In other words, Microsoft's share value bears little relation to its book value.
Book value does not offer insight into companies that carry high debt levels or sustained losses. Debt can boost a company's liabilities to the point where they wipe out much of the book value of its hard assets, creating artificially high P/B values. Highly leveraged companies – cable and wireless telecommunications companies, for example – have P/B ratios that understate their assets. For companies with a string of losses, book value can be negative and, hence, meaningless.
Behind-the-scenes, non-operating issues can impact book value so much that it no longer reflects the real value of assets. First, the book value of an asset reflects its original cost, which is not informative when assets are aging. Second, the value of assets might deviate significantly from market value if the earnings power of the assets has increased or declined since they were acquired. Inflation alone may well ensure that book value of assets is less than the current market value.
At the same time, companies can boost or lower their cash reserves, which, in effect, changes book value but with no change in operations. For example, if a company chooses to take cash off the balance sheet, placing it in reserves to fund a pension plan, its book value will drop. Share buybacks also distort the ratio by reducing the capital on a company's balance sheet (for details, see How Buybacks Warp The Price-To-Book Ratio).
The Bottom Line
Admittedly, the P/B ratio has shortcomings that investors should recognize. However, it offers an easy-to-use tool for identifying under or overvalued companies. For this reason, the relationship between share price and book value will always attract the attention of investors.