Another common valuation measure is price to book ratio (P/B), which compares a stock’s market value with the book value (also known as shareholder’s equity or net worth) on the company’s most recent balance sheet. The idea here is that future earnings or cash flows are ephemeral, and all we can really count on is the net value of a firm’s tangible assets in the here-and-now. Legendary value investor Benjamin Graham, one of Warren Buffet’s mentors, was a big advocate of book value and P/B in valuing stocks.
Although price to book ratio still has some utility today, the world has changed since Ben Graham’s day. When the market was dominated by capital-intensive firms that owned factories, land, rail track, and inventory –all of which had some objective tangible worth – it made sense to value firms based on their accounting book value. But now many companies are creating wealth through intangible assets such as processes, brand names, and databases most of which are not directly included in book value.
For service firms in particular Price to book ratio has little meaning. If you used P/B to value eBay, for example, you wouldn’t be according a shred of worth to the firm’s dominant market position, which is the single biggest factor that has made the firm so successful. Price-to-book may also lead you astray for a manufacturing firm such as 3M, which derives much of its value form its brand name and innovative products, not from the size of its factories or the quantity of its inventory.
Another item to be wary of when using P/B to value stocks is goodwill, which can inflate book value to the point that even the most expensive firm looks like a value. When one company buys another, the difference between the target firm’s tangible book value and the purchase price is called goodwill, and its supposed to represent the value of all the intangible assets –smart employees, strong customer relationships, efficient internal processes –that made the target firm worth buying. Be highly skeptical of firms for which goodwill makes up a sizeable portion of their book value.
Price to book ratio is also tied to Return on Equity (equal to net income divided by book value) in the same way that price-to-sales is tied to net margin (equal to net income divided by sales) . Given two companies that are otherwise equal, the one with a higher ROE will have a higher P/B ratio. The reason is clear – the firm that can compound book equity at a much higher rate is worth far more because book value will increase more quickly.
Therefore when you are looking at P/B, make sure you relate it to ROE.
A firm with low P/B relative to its peers or to the market and a high ROE might be a potential bargain, but you will want to do some digging before making that assessment based solely on the P/B.
Although P/B isn’t very useful for service firms, its very good for valuing financial services firms because most financial firms have considerable liquid assets on their balance sheets. The nice thing about financial firms is that many of the assets included in their book value are marked-to-market –in other words they are revalued every quarter to reflect shifts in the marketplace, which means that book value is reasonably current. (A factory or a piece of land by contrast, is recorded on the balance sheet at whatever value the firm paid for it, which is often very different form the asset’s current value). As long as you make sure that the firm does not have a large number of bad loans on its books, P/B can be a solid way to screen for undervalued financial firms.
