Another common analytical calculation is the price-to-book (P/B) ratio.
Very 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 to compare a company’s market capitalization 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 $40,000 value. You have the choice of two dealers who both sell the model for $40,000. 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).
You are spending $40,000 to get a car now “valued” at $43,010. You believe you are getting a deal and purchase it from the second dealer.
Or perhaps due to sudden financial distress and a slow real estate market, a family needs to sell its home quickly at below market value. If you are in the right place at the right time, you may buy at a nice discount.
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. The idea being that as other investors realize the stock is trading below its actual value, they will purchase shares and cause a price increase.
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.
For value investors, low book values are desirable.
Say a company’s net book value exceeds its market capitalization. If a company distributes its net assets tomorrow, the amount transferred to shareholders will exceed the total value of shares outstanding. A nice safety cushion for shareholders on their invested capital.
Calculating the P/B Ratio
The P/B ratio is found by dividing the share price by the company’s book value per share.
Most free stock quote providers (e.g., Yahoo Finance) offer this analytical information, so no need to calculate.
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? Ideally, shareholders would like to have enough net assets to cover their investment value.
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.
Value Investors Seek Low P/B Ratios
Investors using value strategies often focus on low P/B ratio companies as one of their criteria.
To continue with the Wells Fargo (WFC) example from our price-to-earnings post. Data is as of January 8, 2018, in US dollars, via Yahoo Finance.
WFC’s current P/B ratio is 1.69. That means that the company’s net book value is worth less than its market capitalization.
For value investors, not something they might seek in a stock as they want share price undervalued to its net assets.
A value investor may be more intrigued by Citigroup with its P/B ratio of 0.96. In theory, if the company liquidated its assets, paid its debts, each investor would be able to receive full share value, with a little extra. Whereas WFC shareholders would only receive, in theory, $0.59 for every $1.00 in share value (invert the 1.69 P/B ratio).
Investors really focussing on P/B in the Financial sector may also be interested in AmTrust Financial Services, Inc. (AFSI) or Barclays PLC (BCS). AFSI has an even lower P/B ratio of 0.77, while BCS has a P/B ratio of 0.53.
Growth Investors Less So
Growth investors are more focussed on a stock’s growth potential as opposed to ensuring their capital is covered. As such, P/B ratios are of much less, or no, importance.
Not to mention that growth stocks often have high P/B ratios. For example, Google (GOOG) currently sits at 4.86. Facebook (FB) at 7.64. Amazon (AMZN) at at very heady 24.45.
Not much coverage of investors’ share capital in most growth stocks.
Does that mean investing in growth stocks is a poor strategy? Not at all. Growth investors simply focus on other analytics to assess potential investments.
In Short
In theory, investors’ capital should be quite secure in event of liquidation for low P/B ratio equities.
But is it?
I use “in theory” a fair bit when discussing P/B ratios.
Yes, knowing a company’s book value and its P/B ratio provides investment information. Always a good thing. But you need to be aware of potential problems associated with book values.
We will look at those next time.
