How to use Price-to-Book Value Ratio

techniques May 16, 2018
 

By Puah Soon Lim

To test my student's understanding of the price-to-book ratio in one of my investment classes called the “Building Blocks for Value Investing” held at the SGX Academy, I asked the class to guess if a stock's price to book valuation is better to be below one or greater than one.  Most of them were able to guess correctly, but when I asked them to explain why they categorize a stock's P/BV < 1 or P/BV > 1,  all of them have a hard time explaining the rationale. This is a ratio that is more complex than it looks.

In this article, I will attempt to provide more clarity on the price to book ratio and how to use it in your investment analysis. More importantly, as value investors, how to use this ratio as a value screen.

For those who are keen to test your take on this ratio, the eight companies that I used in class are the following:

Noble Group
CapitaLand Limited
Singapore Airlines
Singapore Telecommunication Ltd
Nestle (Malaysia) Berhad
DBS Bank
Facebook Inc
Microsoft Corporation

I encourage you to rank them as well and perhaps try to explain why you rank them as such. Compare your answer with mine at the end of this article.

The Usefulness of the P/BV Ratio

Let’s talk about why investors find the P/BV ratio appealing and its advantage. First, book value is a rather stable and intuitive measure of shareholders value. It doesn’t require a lot of assumption to be built in as compared to the discounted cash flow approach. The second advantage in using the P/BV ratio is that it is a number that can be reasonably compared across different firms, given that accounting standard does not deviate too much from each other. Finally, there are far fewer firms with a negative book value as compare to firms with negative earnings which would render the price earnings ratio ineffective.

There are several disadvantages as well. First, book value - the denominator of the P/BV ratio - are affected by accounting policy such as depreciation and amortization. When these accounting policies differ widely, the P/BV ratio may then be not useful for comparison. Second, as you have already found out by now, technology and software firms that do not have significant tangible assets may not be an appropriate ratio to analyze. (like Facebook and Microsoft). Lastly, a firm can and do have negative book value after sustain string of adverse earnings reports. See Noble Group.

The Mechanics

There are two key aspects to understanding this ratio. First, you need to understand the ratio itself. Second, you need to decipher the hidden meanings embedded inside this ratio.

Let’s start with the ratio itself. The price to book ratio is defined as:

Price Per Share / Book Value Per Share (or Market Capitalisation  Book Value)

As with all price multiple, the key to unlocking the meanings of the multiple lies in the denominator; in this case - Book Value.

What is book value?

It all starts with the most basic accounting equation that you learn about a company’s financial position:

Assets = Liabilities + Owners' Equities

This equation reflects how assets are funded by both lenders and shareholders. If you want to know the proportional share of what the shareholders own, all you need to do is rearrange the equation as follow:

Owners' Equities = Assets - Liabilities

This proportional ownership of the assets by the shareholders is what is known as the “book value”. The term “book value” itself records what was put into the business by the shareholders. As a shareholder, you want to see the value of this numbers grow. 

Warren Buffett often starts the annual Berkshire Shareholders letter by the following quote: 

“ Berkshire’s gain in net worth during 2017 was $65.3 billion, which increased the per-share book value of both our Class A and Class B stock by 23%. Over the last 53 years (that is since present management took over), per share book value has grown from $19 to $211,750, a rate of 19.1% compounded annually."

He has repeatedly stated that over the long run, book value growth is a good proxy for Berkshire’s intrinsic value growth.

The two terms - book value and intrinsic business value - have very different meanings. Book value is historical and is an accounting term. It is about the recording of accumulated net worth from both initial contributed capital and retained earnings. Intrinsic business value is an economic and finance concept. It is forward-looking. It estimates the future cash outflow from a business and discounts them to present value. The book value itself is a number that tells you what capital has been contributed to the business; whereas intrinsic value estimates what can be taken out of it.

Valuation Application

From a valuation perspective, some assets are more valuable than others. There are two perspectives to take when you value the asset on a balance sheet. You could value the asset at scrap or at reproduction value.

Usually, stocks that are trading at below P/BV < 1 have generally been considered undervalued, while those trading at P/BV > 1 has been targeted as overvalued. I would like to offer that stocks whose P/BV < 1, their assets are being priced at liquidation value. Whereas stocks whose P/BV > 1, their assets are priced at reproduction value.

It’s about Market Value Added (MVA)

So if a stock is trading at P/BV < 1, it means that market deem the asset have this company as not worth very much and can only sell for scrap. Therefore there is no market value added (MVA) to shareholders’ equity (book value). When a stock is trading at P/BV > 1, however, it means that market deems the assets as more valuable and as such there is market value added(MVA).

For example, if the market capitalization of a CapitaLand is

SGD$15.49 billion and the shareholders’ equity in the balance sheet is SGD$19.03 billion that gives us a P/BV ratio of 0.81. What that means is that for every $1 of shareholders’ equity the company has not added any market value. The assets are deemed to be not as valuable and should sell for scrap.  Singapore Airline whose P/BV is 0.91 is in a similar situation whereby there is no market value added.

DBS Bank, SingTel, Facebook, MSFT and Nestle (Malaysia) Berhad, on the other hand, has positive market value added(MVA). All of them have P/BV>1, and their assets are worth more than what is stated in the book. Nestle in particular, with a market capitalization of RM33.24billion, shareholders’ equity of RM862.39million has a staggering P/BV of 38.42. For every RM1 in of shareholders' equity, the company has added an additional RM38 in market value.

With this lens of looking at Price-to-Book as Market Value Added (MVA), now let’s revisit the seven companies that I mentioned at the start to get a sense of what comprises a high, low or average P/BV. Below is a tabulated result of the price to book ratio of the eight companies.

Company

Price to Book

Market Capitalisation*

Book Value*

ROE

Noble Group Ltd

N/A

SGD$102 million

(1075.90)

1.48%

Capitaland Ltd

0.81

SGD$15.49 billion

SGD$19.03billion

12.87%

Singapore Airlines

0.94

SGD$13.18 billion

SGD$14.03billion

4.43%

DBS Bank

1.55

SGD$75.56billion

SGD$48.71billion

3.01%

Singapore Telecommunications Ltd

1.96

SGD$57.95billion

SGD$29.51billion

9.07%

Facebook Inc

5.78

USD$448.5 billion

USD$77.62 billion

28.80%

Microsoft Corporation

9.47

USD$750.6 billion

USD$79.239 billion

37.61%

Nestle (Malaysia) Berhad

38.42

RM33.24billion

RM862.39million

74.98%

Source: www.capitalcube.com as at 14 May 2018

Most have no trouble identifying Noble Group - whose P/BV cannot be computed - the result of continuously losing money and having a negative book value.

DBS Bank, SingTel, Facebook, MSFT and Nestle (Malaysia) Berhad is another group that most people are able to identify. These are well-known companies which have demonstrated a track record of profitability which is essential for growing book value. The one that is difficult to identify would be CapitaLand and Singapore Airline; both are just marginally less than one.

How to use it in your investment analysis?

I have included an additional column in the table with the Return on Equity (ROE) of each company alongside the information for the price to book. From the table, you probably can tell that the ROE Ratio strongly influences P/BV. For those who are interested to know more, you may read up on Professor Aswath Damodaran’s treatment on this subject here.

Companies that have high returns on equity sell for well above book value and companies that have low returns on equity sell at or below book value. The companies that should attract attention from investors are those that show mismatches of P/BV ratios and returns on equity; low P/BV ratios and high ROE, or high P/BV ratios and low ROE. Therefore, potentially I would single out CapitaLand for further investigation. (Low P/BV and high ROE). There could perhaps be an undervalue situation here.

Another application in the screening for value stocks would be to look for deep-value play. So instead of looking for stocks that are trading at P/BV < 1, you want to be looking for stocks trading at P/NCAV < 1. NCAV stands for net current asset value. I have written an article about this category of value stocks here.

In the interest of keeping this article digestible, I will stop here for now. Are there any further insights into the price to book that I have missed? Leave me a comment below.

 

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

 

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