The Price-to-book ratio, or P/B ratio

The Price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company’s book value to its current market price. It is calculated as share price divided by book value per share. Book value is most often calculated as Assets less Liabilities. However, some people conservatively calculate book value as Assets less Intangibles less Liabilities. I prefer the latter since it excludes goodwill and other intangibles which would be difficult to recover in a liquidation.

      P/B ratio = market capitalization / book value of equity

      Market capitalization = shares outstanding x market price per share

      Book value of equity = book value of assets – book value of liabilities
      Book value of equity = Total assets-Intangible assets and liabilities

So therefore,

      P/B = market capitalization / (Book value of assets – Book value of liabilities)
      P/B ratio= market capitalization / (Total assets-Intangible assets and liabilities)

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. 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 we can deduce from a low P/B

A low P/B ratio could indicate a stock is undervalued. Since GAAP accounting is mostly based on historical cost, a viable growing company will normally be worth more than its book value. However, there are times when good companies will be punished along with the bad. It is our job as investors to separate the good companies from those that have fundamental problems.

A low P/B can indicate that assets are overstated on the balance sheet. In this case, we should avoid the company because it may be destroying shareholder value. Ford (NYSE: F) is a good example of this. According to MSN Money Central, Ford’s P/B was 0.72 in 1997, and its book value per share was $25.54. Today, Ford’s P/B is 1.30, and its book value per share is down to $7.66. During that time, the share price has fallen from nearly $50 to less than $10. Clearly, Ford had other problems, but the low P/B certainly did not indicate value. At Inside Value, we generally look for companies that have been increasing book-value-per-share over a number of years because — as Ford’s plight shows — the share price often follows the book value per share.

A low P/B can indicate that the industry at large has a low P/B. Certain industries have low P/B ratios, generally because they are cyclical or because the companies generate relatively low ROE. Insurance companies typically have low P/B ratios because of the cyclicality of that industry. This attracts new capital in the short term, when investment returns can be very good. After a while, however, competition increases and the market softens. It’s important to find insurance companies that maintain discipline in a soft market. Otherwise, they’ll take on risks that are not adequately covered in the premiums. Eventually, claims will roll in, along with underwriting losses, and the book value will be reduced.

Best use of P/B

P/B is best used for asset-heavy companies, such as financial institutions, manufacturing companies, and other capital-intensive industries. Companies with a regular inflow of new assets, such as capital expenditures in the case of DaimlerChrysler (NYSE: DCX) or more cash in the case of JPMorganChase (NYSE: JPM), are likely to have book values that at least relate to market values (e.g., at around 1.2 for the P/Bs of Daimler Chrysler and JPMorgan). In both cases, a lower-than-average P/B ratio compared with past years may indicate a value opportunity. Comparing it to the S&P 500 average P/B of 2.84 (according to Barra) is meaningless as a measure of value.

As with most ratios, be aware that P/B varies by industry. Industries that require higher infrastructure capital (for each dollar of profit) will usually trade at P/B much lower than the P/B of (e.g.) consulting firms. P/B ratios are commonly used for comparison of banks, because most assets and liabilities of banks are constantly valued at market values. P/B ratios do not, however, directly provide any information on the ability of the firm to generate profits or cash for shareholders.

For value investors, P/B remains a tried and tested method for finding low price stocks that the market has neglected. If a company is trading for less than its book value (or has a P/B less than 1), it normally tells investors 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 well advised to steer clear of 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 doesn’t happen, a company trading at less than book value can be broken up for its asset value, earning shareholders a profit.

P/B distortions 

Despite its simplicity, P/B doesn’t do magic. Distortions in P/B arise because book value of equity is more an accounting measure than an economic measure.

First of all, the ratio is really only useful when you are looking at capital-intensive businesses or financial businesses with plenty of assets on the books. Thanks to conservative accounting rules, book value completely ignores intangible assets like brand name, goodwill, patents and other intellectual property created by a company. Book value doesn’t carry much meaning for service-based firms with few tangible assets. Think of software giant Microsoft, whose bulk asset value is determined by intellectual property rather than 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 doesn’t really 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 – like those involved in, say, cable and wireless telecommunications – 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. For starters, the book value of an asset reflects its original cost, which doesn’t really help when assets are aging. Secondly, their value 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.

Admittedly, the P/B ratio has shortcomings that investors need to recognize. But it offers an easy-to-use tool for identifying clearly under or overvalued companies. For this reason, the relationship between share price and book value will always attract the attention of investors.

Here are a few natural distortions to watch out for:

Companies that have very long-lived assets (like real estate) still on the balance sheet at original cost (i.e., the book value) will have understated assets and, therefore, an understated book value. All other things equal, the effect will be an increase in the P/B ratio. In this case, you might miss an undervalued company by simply looking for low P/B ratios.

Service companies, and those that rely on intellectual property (IP), are not capital-intensive, and they do not have significant assets recorded on the balance sheet. A good example is Microsoft (Nasdaq: MSFT). At the end of its 2004 financial year, Microsoft had $94 billion in assets, with a full $60.6 billion in cash and equivalents, $10 billion in other current assets, and only $22 billion in longer-term assets. Nearly all Microsoft’s IP was developed in-house and is not capitalized on the balance sheet — and it can’t be, because IP must be expensed on the income statement under U.S. generally accepted accounting principle rules.

Recent acquisitions will generally increase the book value and lower the P/B because the new assets go on the balance sheet at the full price paid. In the unlikely event that Microsoft acquired Oracle (Nasdaq: ORCL) and all of its IP for $70 billion in shares, the full $70 billion would be recorded on the balance sheet as an asset. The amount in excess of Oracle’s $11 billion book value ($59 = $70 – $11) would show as goodwill.

A serial acquirer of other companies will almost always have a high book value, which may artificially lower P/B. However, a huge part of the book value will be in goodwill or intangibles. In this case it is prudent to subtract goodwill from book value, resulting in a “tangible book value.” We can then calculate the more meaningful “price-to-tangible-BV ratio.”

Recent write-offs will reduce the book value of equity. Companies typically say that this is a non-cash charge, yet in a real sense it reduces the value of shareholder equity. It may not show up in the P/B ratio because as companies reduce the “B” via write-offs, investors reduce the “P” via a lower stock price.

A company that has a history of buying back a large number of shares will have a lower book value. All of the shares bought back go into what is called “treasury stock” at the full buyback price, and these are subtracted from book value. The original shares are recorded at par value, which is usually as low as $0.10 to $1.00 per share. A good example is Inside Value newsletter pick Anheuser-Busch (NYSE: BUD), which in the past four and a half years bought back 140 million (15%) of its shares. Book value is just $3 billion, yet the company has almost $15 billion in treasury shares. Without any buybacks the book value would be around $18 billion. A really good indicator here is that both the P/B and the ROE will be extraordinarily high. For Anheuser-Busch, P/B is 11.7 and ROE is 75, which are extraordinarily high and of little use in assessing the value of the company. To overcome this, we can use a BV adjusted for share buybacks. This would reduce the P/B to 2.0 and the ROE to around 13.

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