The Price-to-Book Ratio of a stock can be used to compare a company’s market value with its accounting value. The price-to-book ratio can be used to analyze the valuation of companies. We discuss how to calculate it, as well as its advantages and weaknesses.
- Advantages of using the Price-to-Book Ratio
- Limitations of the Price-to-Book Ratio
The price-to-book ratio compares a company’s market capitalization with its book value on the balance sheet. It is an easy way to find how much we are paying today for every dollar that was originally invested in the company or earned through profits.
The calculation of the price-to-book ratio (P/B) is very simple. First, we need the company’s market capitalization. This is a metric readily available and tells us the market value of all outstanding shares combined. It is the price we would have to pay to acquire 100% of the company’s shares at current market prices.
After that, we need the book value of the company. The book value of a company is the difference between its assets and its liabilities. Therefore, it is how much assets the company owns minus all its debts. The book value of a company is also known as its equity.
Once we have the market capitalization and the company’s equity, we simply divide the former by the latter. Alternatively, we can dividend the company’s stock price by the book value per share. The book value per share is the company’s equity divided by the number of shares outstanding. Both methodologies should yield the exact same result.
Let us use an example to see how the price-to-book ratio is calculated. As of December 31st, 2019, Nestlé had assets worth CHF 128 billion. At the same time, its total debts amounted to CHF 75 billion. Thus, Nestlé’s equity was 53 billion. If we divide this equity by the total number of shares, we get a book value per share of CHF 16.86.
At the end of 2019, the stock price was CHF 104.78 francs. Therefore, its price-to-book ratio was 6.2 = 104.78 / 16.86. For every Swiss Franc of equity in the balance sheet, we must pay 6.2 Swiss Francs to acquire the shares.
There are many reasons for that. Let us analyze the price-to-book ratio in more detail.
Advantages of using the Price-to-Book Ratio
The price-to-book ratio has some good applications and advantages when it comes to analyzing stocks:
1) Easy to Use
One of the main advantages of using the price-to-book ratio is that it is very easy to use and understand. If the ratio is higher than 1, we are paying more for the stock than the amount that has been invested and retained in earnings. Although there may be very good reasons for that.
A ratio greater than 1 usually indicates that the company is running a profitable business with a strong market position. As a result, that market position could not be taken by a competitor by simply investing money, since other aspects such as products, brand, the dealer network, customer loyalty, etc. take time to develop.
If the ratio is below 1, we are paying less for the stock than was originally invested. This can make us think we are getting a bargain. But, again in this case, there may be good reasons for that such as the company’s business being in decline.
2) Useful for some sectors
The sectors for which it is most useful to use the price-to-book ratio are those that require a lot of capital and sell relatively commoditized products or services. This means companies do not have the option to customize what they offer to their customers.
Some of these sectors would be banking, insurance, energy, transportation and some industrial companies. As you can see, all of them require large capital investments. And, at the same time, all companies within the sector offer pretty much the same products and services.
Let us use the insurance sector as an example. The important thing when buying an insurance policy is not the logo that appears on the contract. The important thing is the premium we pay, its coverage, and a good track ratio of paying claims. In addition, a strong capital position is also a positive.
Such sectors tend to have lower price-to-book ratios, since new companies could easily enter the business otherwise. A lower ratio, which means a lower valuation, does not make it profitable for entrepreneurs to simply try to compete by raising capital.
3) Useful to compare companies within the same sector
For certain sectors, the price-to-book ratio is often useful to compare the valuations of competing companies. The big oil sector would be a good example.
Companies such as Total, Royal Dutch Shell and Exxon are some of the world’s largest oil producers. As of mid-July 2020, its price to book ratios were 0.9, 0.75 and 1.05, respectively. Though not exactly the same, they are in a narrow range.
By only looking at these ratios, we would not be able to determine that Shell is undervalued and Exxon overvalued. Though in the same sector, their businesses are not exactly the same. And neither are their organizational structures or solvency levels. However, it is still an important piece of information.
It should be noted that all these companies had ratios close to 1, which proves their large capital requirements. Consequently, it is difficult for these companies to see their valuation ratios grow. The only sustainable way for them to see their valuations increase is by making more profits and paying out larger dividends.
4) It tells us about future market expectations
The price to book ratio can also be used to guess the market expectations for the future of a sector or company. A high ratio indicates that the market believes the sector will probably grow in the future. As a result, every dollar invested today will end up returning a significant amount of capital, and the ratio is anticipating that.
On the contrary, a very depressed ratio anticipates a bleak future. On the one hand, it would reflect the potential inability of that sector to generate profits in the future, since every dollar invested is valued at less than a dollar.
At the same time, it also tells us that the assets of that sector or company could not be sold at their book value. After all, if that was possible, someone could buy all the shares of a company, liquidate their assets, and make a profit. That happened quite often in the decade of the 1980s. This is one of the themes of the great movie Wall Street, starring Michael Douglas.
It is worth highlighting how low price-to-book ratios are for the European and Japanese banking sectors, with many banks trading at ratios lower than 0.5. This indicates the market is willing to pay less than 50% for the value of the assets that appear on a bank’s balance sheet.
Bank valuations are used a signal by some institutional investors to assess the state of the economy in the future. Low bank valuations may be premonitory of an economic recession and a wave of bankruptcies.
Limitations of the Price-to-Book Ratio
Next, we will speak about the disadvantages or limitations of using the price-to-book ratio to analyze stocks:
1) An asset’s accounting value may be inaccurate
The price-to-book ratio is calculated using accounting values available in the balance sheet published in the company’s financials. However, most assets are valued based on their historical cost on the balance sheet, rather than their current market value. This has important consequences when analyzing companies.
Some assets may be significantly undervalued according to their book values. Imagine a real estate company that acquired properties a few decades ago and has not revalued them on its balance sheet. Similarly, some companies with heavy machinery may own assets that are worth a lot more than their book value.
On the other side, many assets may be booked at values that are much higher than their actual market prices. This happens often when companies have been doing acquisitions and overpaying in the process. As a result, there will be a large asset called goodwill on the balance sheet. Goodwill is not a real asset as it cannot be sold. It is there to reflect how much the company overpaid to acquire some smaller businesses in the past.
By a similar note, some financial institutions may report non-performing loans at their original value. Of course, if those loans were to be sold, their market value would be significantly lower as they are effectively defaulted.
Finally, it should be noted that, in many instances, it is difficult to know for sure what the value of a company’s assets is. This is especially true for software companies that own plenty of intangible assets, such as Microsoft or Google.
2) Off-balance sheet assets
Another limitation of the price-to-book ratio is that it does not consider certain very valuable assets. The most important of all is the value of a company’s brand. For example, everyone would agree that the value of the Coca-Cola brand is immense. However, it is not an asset that the company can show on its balance sheet.
Other key assets that are not on the balance sheet either would be the following: a star CEO, like Elon Musk for Tesla, the value of software that has been developed or acquired and can be sold around the world, which applies to companies like Microsoft, or the value of network effects for social media companies.
Consequently, it is difficult to use this ratio for certain types of sectors.
3) Only useful to compare similar companies in similar sectors
Finally, it should be noted that the price-to-book ratio, as we discussed before, is generally only useful to compare similar companies in similar sectors.
It does not work well to compare companies whose business model are completely different, or even sectors that have very different dynamics. Imagine comparing Nvidia with JP Morgan. Or the technology sector with the materials sector.
Companies and sectors that run different business models, have different growth rates, are exposed to different types of risks, etc. are difficult to compare by focusing on a single metric.
As we have analyzed, the price to book ratio can be very useful to analyze some sectors of the stock market. Though it has its limitations, it certainly has a place when it comes to fundamental stock investing.
It can also be used to gauge market sentiment about specific sectors or companies. Very depressed levels would indicate the market is pessimist about their future, while elevated levels would be the sign of optimism. Perhaps too much optimism.
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