The price-to-book ratio is for the most part a completely useless valuation method. Indeed, unless calculated personally, with a keen eye for detail and rigorous analysis of company finances, the ratio can be highly misleading.

Price-to-Book Ratio

Reasons for wrong price-to-book valuation

There are basically three main reasons why the price-to-book valuation is wrong. Firstly, the valuation includes items like goodwill and patents, intangible items that have no intrinsic value. The value of these items can quickly disappear.

For value investors who use the price-to-book valuation method on the basis that the downside is limited if the company is trading at a price-to-book ratio of less than one, a sudden revaluation of intangible items could quickly change the company’s valuation.

Intangible assets have no identifiable value—they are only worth what someone is willing to pay for them at that point in time. The best example of this was during the run-up to the financial crisis when the majority of MBS’ assets on banks’ balance sheet books turned out to be virtually worthless. Caterpillar Inc. (NYSE:CAT) and Hewlett-Packard Company (NYSE:HPQ) faced similar write-down’s earlier this year as they realized that they had overpaid for acquisitions and had to write-down goodwill on their balance sheets, causing an adjustment in book value; this problem can be overcome by using the tangible-book-value figure, which is slightly more reliable but is often unquoted.

The second issue with price-to-book value is the valuation method used, and the fact that the book value is only taken at one point in time. For example, many gold miners are currently trading at a price-to-book value of less than one. However, this figure includes the value of their gold mines which is a valued based on the price of gold being at a significantly higher price that it is now. In particular, Barrick Gold Corporation (NYSE:ABX) (TSE:ABX) recently took a $8.7 billion write-down after revaluing its mines based on the lower price of gold, adding to the +$20 billion in write-downs the whole gold mining industry has already taken this year. REITs are also subject to this issue with rapidly changing property prices.

The third reason that price-to-book value can be highly misleading is the issue of window dressing. In particular, using off-balance sheet items or special purpose vehicles to hide debt and toxic assets. Netflix, Inc. (NASDAQ:NFLX) is a good example.

Netflix shares look solid, but are they?

At first glance, Netflix, Inc. (NASDAQ:NFLX) appears solid—shareholder equity stands at $1.1 billion, and debt is low, giving a book value of $22 per share. However, reading through the company report it appears that the company has $3.3 billion in off-balance-sheet content liabilities, which gives the company total liabilities of $5.7 billion, equating to 127% of all Netflix’s assets, and this gives a shareholder equity of -$1.2 billion, leaving no margin for error. Many banks use this method to hide toxic liabilities, Lehman’s repo 105 facility for example.

Still, the price-to-book ratio is not completely useless and can be handy in making an investment decision, especially for the value investor. Having said that, the tangible book value is a more telling indicator or value as it rules out large amounts of goodwill, patents and intangible items, which can cause more trouble than they are worth.