Problems with Price-Book Ratios

There are a few problems with using book values to assess company and per share value.

We shall review those, as well as look at how to improve the usefulness of Price/Book (P/B) ratios.

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. The farther out the time to cash realization, the less connected is the book value to market value.

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.

In a depressed real estate market, a forced sale of the company factory may realize significantly less than book value.

You must consider whether book value approximates realizable value. And how much realizable value may differ from an orderly sale (where you can bide your time to receive market value) versus a fire sale.

Book Value is a Balance Sheet Concept

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

In general, that is always a problem with balance sheets. They are simply a snapshot at a specific date. By the time you receive and review a company’s financial statements, up to 6 months may have passed from the balance sheet date. Much may have happened in that period to alter the company’s current financial position.

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.

Book value does not factor in key management’s value to a company. Warren Buffett is the standard example here. But many companies have key employees who add value to the business.

Same with intangible assets that tend not to be included in book value calculations. Patents, goodwill, etc., do bring actual benefit to the company.

This holds true for competitive advantages, such as being a monopoly or possessing large barriers to entry in a market.

That is why the “whole should be greater than the sum of the parts.” Many things not factored into P/B ratios are important to a company’s success.

When considering companies, look at how they use their scarce resources to strengthen the business. Not simply whether they have resources. And never ignore intangible assets or competitive advantages that may exist.

Low Book Values May Be Deceptive

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

In this age of technology and information, investors tend to have access to the same data and calculations in real time. You most likely are not the only person to recognize a particular stock has a P/B below 1.0.

If other investors identified the low P/B stock as an opportunity, they would begin to purchase shares. Increased demand drives up the share price, thereby adjusting the P/B ratio higher.

As with the price-to-earnings ratio, you need to ask yourself why these other investors are not buying shares in the company. Perhaps because they believe the company is truly worth less than its net assets. Often due to perceived weak future expected performance, a potential for lawsuits, etc., that over time will cause the asset base to 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.

If you identify a low P/B stock and it looks attractive, perhaps you are a shrewd investor. Just realize that there are many other investors out there who saw the same data as you and did not buy.

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 to help separate the good from the bad.