Chapter 21 – Valuation concept (P/B ratio)

Price-to-Book ratio (P/B): P/E shows the valuation of a company w.r.t. the earnings. P/B on the other hand shows the valuation of a company w.r.t. the book value of Shareholders’ equity. As we discussed, Shareholders’ equity is the difference between Total assets and Total liabilities, i.e. whatever assets are left after fulfilling the obligations of the company. The ratio is calculated as below:

P/B = Market price per share/ Shareholders’ equity per share

While calculating the book value (shareholders’ equity), we should add a small adjustment. We should deduct the value of Goodwill and Intangibles from the Shareholders’ equity as these assets can not be sold at the time of company’s liquidation.

Let’s work this out through an example:

A company XYZ has 1,000 shares. And the latest balance sheet is as below (all numbers in USD):Book value, P/B, Price to book ratio, valuation, PB ratio, Intangibles, Goodwill

As per above, we should not use $7,050 as the Shareholders’ equity since we can see Goodwill and Intangibles on the asset side. We will use the following number instead:

Tangible Shareholders’ equity = 12,050 (Total assets) – 5,000 (Total liabilities) – 1,500 (Goodwill) – 1,000 (Intangibles)

= 4,550

Now divide this by the number of shares to get the Book value per share = 4,550/1,000 = $4.55 per share

Assume that the share price is $5.00 today. So let’s calculate the P/B = $5/$4.55 = 1.1. This means that the market is pricing the tangible assets at a value greater than book value of equity. Reasons for this could be:

  • Intrinsic value of Goodwill and Intangibles: The market realises the capability of assets to earn more than the book value of stock. For example, the company records Goodwill based on the money it paid over and above the Acquiree company’s shareholders’ equity. But it also buys the expertise, infrastructure, customer base, distribution network etc. which can probably produce more income in future than the balance sheet can represent. The reason for this disparity is that the balance sheet is created as of a specific date and does not estimate the future value of assets.
  • Hidden asset: The market realises that there is a hidden/undervalued asset on the balance sheet. For example, the company bought a property in New York in 1950 and has been showing it at the original cost of purchase. An enterprising investor made other investors aware of this fact and hence the market started pricing the book value upward accordingly.
  • Just a bull market phenomenon: It’s a bull market and there is no regard for fundamentals at the moment. Needless to say, we will keep ourselves away from such scenarios.

Please note that P/B is only one of the other metrics that we have discussed until now. A good way to start searching for value would be to look at companies with P/B <1. It might eliminate some companies with high values of Goodwill and Intangibles (eg. Pharmaceuticals & IT). But if you are fairly confident of analysing the future prospects of Intangibles based on the underlying business, it might result in some good investment opportunities.

Chapter 20 – Valuation concept (P/E ratio)

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Chapter 11 – Non-current assets

Yes, you are right, these assets are not expected to be converted into cash in one year’s timeframe. The line items that fall under Non-current assets are as below:

  • Plant, property and equipment: This category represents the infrastructure used by the company to conduct its business. Plant and equipment refer to the factories or labs or place of production of goods. Since these items have a fixed lifespan, their value is depreciated every year, as discussed in Chapter 4. Property, however, is usually recorded at the cost of acquisition of land. Some companies state Property at the current market value or provide an estimation of current value in the footnotes. A value investor would always be on the lookout for disparities in the value recorded on balance sheet vs the values that represent reality. Such a disparity can occasionally result in very profitable opportunities. Let’s say a company owns a land in New York City but has recognised it only at the prices of 2008, there might be a chance to benefit from this situation. These assets are also known as Fixed Assets as they are can not be physically moved from one place to another. Technically, the equipment can be moved, but it is very rare for a business to change the location of factory itself as it would involve a ton of expenses to move all the equipment to setup production in a new location.
  • Intangible assets: As can be imagined, these assets can’t be touched or felt. Patents, copyrights, trademarks etc. fall under this category. Pharmaceutical or IT companies are expected to have substantial amount of Intangible assets due to patents on drugs and processes.
  • Goodwill: This is usually recorded when a company acquires another company and pays more than the current value of Equity (Assets – Liabilities) of the company being acquired. Why does any company pay more than the current market value? Because it estimates to generate more value in the future from this acquisition compared to the price paid at present. Let’s say there are 4 major companies producing beers in the world with top 2 dominating the market with 70% market share (say company A and B) while the other 2 companies with a market share of 20% between them (say company X and Y). Company X decides to acquire company Y so that the combined company can compete with companies A and B. For this X buys Y at a higher price as it expects to increase the reach of its products, increase the margin and improve the competitive landscape for a profitable future. That said, goodwill is not always a good sign on the balance sheet. A lot of acquisitions have gone sour because the companies could not achieve the desired synergies due to cultural incompatibility, operational issues or any other reasons. We don’t have to do a detailed analysis for this, but having a sense of whether the goodwill is good or bad for the particular company would help. One way of understanding this is to check if the company is charging impairment of goodwill either to the  Income Statement or directly to the impairment reserves in Shareholders’ equity. If there is an impairment charge in the years following the acquisition, it can be considered as an admission of mistake by the company in over-paying for the acquisition
  • Long term investments: These investments could be in form of securities (bonds, stocks etc) or investments in non-listed companies. These are categorised as Long term investments because the company doesn’t intend to liquidate them before an year with a view of earning a good return on investment.

Other than the above, some other categories also fit in Non-current assets which can be ignored if not significant as a proportion of total assets. These include – Deferred tax assets and Other Assets.

Types of assets are done! That was easy! Now let’s dig into the Liabilities from next chapter onwards.

Chapter 12 – Current Liabilities

Chapter 10 – Current assets