We have a whole series of articles on valuation metrics – you can read them here – General article – PE – PEG – Significance of Comparing Enterprise Value to EBITDA and Analysis using free cash flow.
Analysis of a potential target company could begin with a comparison of the price to the book value of equity. Using this metric the current share price is divided by the book value of assets minus liabilities. The result therefore shows the number of times the book value investors are paying for shares. This can be instructive for the potential investor in shares of the company but further analysis is necessary to understand the significance of this calculation when applied to any particular corporation.
There are obvious problems in applying the price to book ratio. One problem is that the book value of the assets may not bear much relation to their market value and this can affect the conclusions that could be drawn from applying the ratio. Although tangible assets may often be revalued and therefore appear on the balance sheet at a reasonable valuation, intangible assets are often not valued correctly or even not recognized at all. The problem stems partly from the inherent difficulties in valuing intangible assets and partly from the flexibility left by accounting standards in accounting for intangibles. A company whose shares appear to be priced at three or four times the book value of the assets minus liabilities could be using valuable intangible assets including goodwill that are inadequately recognized or accounted for on the balance sheet. An accurate valuation of these intangibles would result in a lower price to book value.
Another problem with the ratio, closely connected to the first problem above, is that it does not yield very much information when applied to businesses that are providing services rather than dealing in goods. A consultancy company for example will only have minimal assets and will rely on the knowledge and experience of its workforce to earn its profits. The price to book ratio will therefore tend to show that investors are prepared to pay many times the book value of assets for shares of the company. The knowledge of the workforce is of course a type of intangible asset but one that is not recognized in most accounting systems and is not assigned any value on the balance sheet. Accounting standards are constantly being improved and upgraded but are still falling far behind developments in the knowledge based economy.
Despite these problems in using the ratio, the price to book ratio can give a reasonable result when applied to a capital intensive enterprise or to a company that is dealing in financial assets. These types of enterprise have enough assets on the balance sheet and those assets are making an important contribution to their profits.
If Share Price is Less than Book Value
If a company’s share price is less than the book value this could mean that the investors do not believe the value of the assets less liabilities is as great as stated in the accounts. The investors may have reason to believe that the book value of some of the assets is overstated on the balance sheet. The value investor should investigate the reason why investors may not have confidence in the book value. If they have good reason for their lack of trust in the book value then there may at some point be a reduction in the asset values on the balance sheet that could damage the company’s standing and put downward pressure on the share price. In this case the investor should not think of buying the shares.
Alternatively, the company’s return on equity could be very poor and this could be leading investors to value the company at below the book value. This could be due to poor management or the choice of a poor business strategy. In these circumstances, adoption of a different business strategy by the management or a change of management could lead to a change in the fortunes of the company. For example, a retailer may own a large number of outlets that are not earning a sufficient return and the solution may be to close the outlets that are not performing well enough, selling the property if necessary. This streamlining of the business by retaining the most profitable outlets could lead to a dramatic increase in the return on equity and an increase in the share price.
The only way an investor can identify the real reason for a low price to book value ratio is to perform further research and use alternative metrics to analyze the company’s business. For example, looking at ratios such as the return on equity will give a clue as to the reason for the position. The investor may also look at the annual report of the company and look at the plans of management for the future. If there is any sign of a future change in management strategy that would increase the return on equity there may be an investment opportunity.
If share price is more than book value
Where the share price is considerably more than the book value the conclusion could be that the return on equity is high. Although this is good news for the company and means that management is probably pursuing the correct strategy it may also mean that the strengths of the company are already taken into account in the price of the shares. The market value of the company may be very close to its intrinsic value and this means that the shares are of no immediate interest to the value investor. The investor should make a note of the company and take another look if the share price later becomes depressed for irrational reasons such as a general downward move in the market resulting from emotion rather than logic.