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Price-to-Book Ratio

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Another common analytical calculation is the price-to-book (P/B) ratio.

This is popular among value investors.

While price-to-earnings considers a company’s future earnings potential as a way to determine share price, P/B incorporates what the company owns.

Not a ratio that I find very useful, but many others do, so you shall not suffer for my biases.

We will cover how to calculate and use P/B ratios, followed by limitations in the ratio’s effectiveness. Then I will show you how to make the P/B ratio a little more practical. 

Price-to-Book Ratio

The P/B ratio is used by investors to compare a company’s market capitalization [4] to the book value of its net tangible assets.

Think of it like buying a new car during a slow sales period. According to your research, the car you want has a $30,000 value. You have the choice of two dealers who both sell the model for $30,000. Neither can go below that amount due to price obligations with the manufacturer.

One dealer is firm on the price. The second dealer is more flexible. To get your business, he upgrades the stereo system ($2000 value), adds air conditioning ($1000) and a pair of fuzzy dice for the mirror ($10).

As you are spending $30,000 to get a car now valued at $33,010, you believe you are getting a deal and purchase it from the second dealer.

The same principle holds true for shares. You are trying to buy something for a price less than its worth, as valued by its assets on a per share basis.

If a company’s net assets are worth more than the price of its shares, it may be a value stock.

Book Value

Book value, or as I prefer “net book value”, is found by taking total assets on the balance sheet and then subtracting all liabilities and any intangible assets.

Intangible asset are assets that are not tangible (physical) in nature. Intangible assets include: goodwill, patents, trademarks, intellectual property.

Note that while deducting intangible asset book values is normal practice, I do not do so myself. Some intangibles may have actual value – a patent or brand name, for example – that will be worth something in the event of a company sale. What that value is varies from company to company based on its unique situation. But keep in mind that intangibles may have value even if they generally are excluded from net book value calculations.

Calculating the P/B Ratio

The P/B ratio is found by dividing the share price by the company’s book value per share.

Some investors use the P/B ratio to assess a fire sale scenario. If the company shut its doors tomorrow, what is the value upon dissolution and distribution of assets to shareholders?

In value analysis, low P/B ratios are sought.

Any P/B ratio less than 1.0 indicates that the per share book value of the company is worth more than the share price.

The higher the ratio, the less chance that the company’s net assets can cover the share value.

To continue with the Barclays example from our price-to-earnings post [5].

Barclays current P/B ratio is 0.72. That means that the company’s net book value is worth more than its market capitalization.

For value investors, this is interesting. It assumes that if the company distributed its net assets tomorrow, the total amount transferred to shareholders would exceed the market capitalization of the shares outstanding. A nice safety cushion for shareholders.

When we review the Financial sector, the average P/B ratio is 1.57. Within the Foreign Money Center Banks industry, the P/B is 1.09. These are both positives for value investors as Barclays ratio is significantly lower than either.

Based on the P/B ratio, it appears Barclays may be undervalued in price as compared to its industry and sector. So it may be a value stock.

But is it?

Problems With Book Values

There are a few problems with using book values when assessing company value.

Book Value is Not Liquidation Value

The book value of a company’s net assets may not be the same as upon liquidation.

As a general rule, the closer an asset is to cash, the closer the asset’s book value is to its liquidation value.

For example, cash is cash. Current assets such as trade receivables and inventory are relatively close to cash realization value. But for fixed assets like vehicles, equipment, and real estate, there might be large differences between book and realizable values.

At times this may be a positive, such as when the real estate market is strong and a 20 year old factory is listed at its original purchase price.

Often though, it is a negative.

Perhaps the company owns a fleet of vehicles that it is depreciating straight-line over 5 years with zero residual value. That means that after year one, the vehicles are still valued at 80% of the purchase price (divide price of vehicle by 5 years of straight-line depreciation. End of first year, vehicles will have a book value of 80%. Second year, 60%. Third, 40%, etc.). But if one needs to sell them at the end of year one, it may be difficult to get that high a sales price.

And in today’s depressed real estate market, maybe a forced sale of the company factory will result in significantly less than book value.

Book Value is a Balance Sheet Concept

Book values are based on balance sheet values that took place at a single point in time.

But what happens when most companies need to liquidate?

Liquidation is usually due to poor operating results that cause losses and negative cash flows. Even if the current balance sheet appears strong, losses and net cash outflows will quickly erode the future book value of a company.

There may be lawsuits from customers, shareholders, governments, or other parties that force the company to ultimately liquidate. Fines, lawyers fees, etc. will also lower book value.

Employees may need termination packages upon liquidation. As a going concern, a company would not account for these costs on its books. But they may need to be paid.

Just because a company’s book value is currently greater than its market capitalization, it does not guarantee anything about the future book value.

As the business deteriorates, so too will its book value. If you invest today, based simply on a P/B less than 1.0, you may find in a year or two, the ratio has increased significantly.

A Company’s Value Should be More than a Sum of its Parts

A company’s value should be based on how it employs its assets and less on the assets themselves.

A company could own a large factory filled with manufacturing equipment. But if it does not produce a product that meets the needs and desires of its customer base, it will have no sales.

That is why the “whole should be greater than the sum of the parts.”

When considering companies, look at how they use their scarce resources to strengthen the business. Not simply whether they have resources.

Low Book Values May Be Deceptive

A low book value is usually seen as a positive to the value investor.

As with the price-to-earnings ratio, you need to ask yourself why other investors believe the company is worth less than its net assets. Often it is because the company’s expected performance is such that over time its asset base will deteriorate.

As we saw above, if a company’s net earnings and cash flow cannot pay its ongoing obligations, the company will have to liquidate existing current and fixed assets to pay its debts. This will reduce future book value and make the company much less of a value.

Adjusted P/B Ratios

While I do not use P/B ratios in my analysis, I do use an adjusted P/B ratio.

First, I start with a company’s net book value as traditionally calculated.

Second, I add back any intangible assets that I believe hold some residual value.

Third, I review the balance sheet and try to adjust any assets to better reflect realizable values.

For example, if a fleet of vehicles is on the books at 80% of their purchase price, I may attempt to assess their proper value if sold on the open market. Usually I consider both a normal sale and any price change should there require a distress selling price. Maybe an ordered sale will provide 60% of the original price and 40% for a distress sale.

In short I am attempting to perform a business valuation on the company to assess its real value, not simply a book value.

Then I use that data in comparison with the company’s market capitalization.

If I am concerned about a company’s potential bankruptcy, I would probably skip it as investment. But if I did attempt to value the business, I would also factor in any costs normally associated with liquidations.

Not a fool-proof method, but infinitely better that using net book value alone.

Note that if you use an adjusted P/B, you must be careful when comparing it against competitors, industry, or market averages. The reason is that the other metrics are not adjusted, so you need to avoid comparing apples to oranges.

Never Forget the Qualitative Analysis

Exactly the same advice as with the price-to-earnings analysis.

Low P/B stocks may indicate value investments.

But they may also indicate junk companies on a short road to bankruptcy.

You must always consider the qualitative side [6] to help separate the good from the bad.