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):
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)
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)