Definition of Book Value
“Book Value” as the name suggests, is the value of the Company as per its “Books” i.e. its balance sheet. It is the value that company’s shareholders would receive after company liquidate all its assets and satisfy all its short-term and long-term liabilities. Theoretically, book value of a company is the difference between value of its total assets and total liabilities therefore, it is also called as “Net Asset Value” and “Shareholder’s Equity”. The book value doesn’t take into account the value of intangible assets like patents and goodwill; therefore, their value is subtracted while calculating Book Value.
The book value of capital-intensive businesses, including large manufacturing ventures, transportation firms, airlines and automotive companies is higher as they have plenty of fixed assets and investments as compared to the companies in service industry or pharmaceuticals industry which have very few tangible assets and have more of intangible assets like goodwill and patents which are not accounted in calculation of book value.
Also Read: Importance Of Book Value
Definition and Calculation of Book Value per Share
Book value is generally calculated on “per share” basis known as book value per share. Book value per share (BVPS) is financial measure that represents a per share assessment of company’s shareholder’s equity. It is very crucial to understand how preferred shares and common stock are accounted for while calculating book value per share. Typically, when we talk about book value, it is book value per common stock and does not include preferred stock. The preferred stockholders receive dividends before common stockholders when company generates positive earnings and presence of equity from preferred stocks will dilute the book value for the common stock, therefore it is excluded from the calculation of BVPS.
Also Read: Book Value Vs Market Value
The table below illustrates a sample balance sheet of XYZ Corporation as of December 2017. The total assets of the company are valued at approximately $45.0 million and value of all liabilities stood at $35.0 million as of 2017, thus the book value of the company equals $10 million ($45 million – $35 million).
Now, let’s suppose that 1 million shares of company’s common stock are outstanding, and equity is $10 million, then Book value per share is $10 ($10 million/ 1 million). Value investors compare the book value with market value to judge if the company’s stock is underpriced or overpriced.
Book Value per Share for Valuation
‘Price/Book Value per Share’ (P/B) ratio is one of the most significant financial ratios used for relative valuation. It helps value investors to identify stock opportunities and evaluate attractiveness of a stock, especially in capital intensive sectors. It is also called as Market – to – Book ratio and can be calculated in two ways:
- The first way is, Company’s market capitalization can be divided by company’s total book value derived from its balance sheet.
- The second way is to divide company’s current stock price with its book value per share.
With reference to the balance sheet above for XYZ Corporation, let’s assume that the current market price of the stock is $70 and book value per share is calculated as $10, then Price – to – Book value will be equal to 7. A P/B ratio of 7 would efficaciously mean that for every $1 of net tangible assets, there is market value of $7 and it measures how much shareholders are paying for the net assets of the company.
Mechanics of Higher P/B
Higher market value of the company as compared to book value per share, produces a P/BV above 1. It could mean that the company’s stock is overvalued. Typically, market value is more than book value producing a P/B greater than 1. There are two reasons that explain this phenomenon:
- The market is confident about company’s capacity to generate enough profits and cashflows in future.
- The market believes that the value of assets of the company are undervalued.
Mechanics of Lower P/B
A lower P/B reflects that the company is undervalued and attracts investors seeking growth at reasonable price as buying at low P/B leads to better returns. P/B less than 1 means that the book value of the company is higher than the current market price and thus represents a lucrative buying opportunity. However, a thorough analysis of factors bringing down the value of P/B need to be done before making an investment decision as a lower P/B not always signifies that the stock value is understated, it may also mean that it is an under-performing stock. The reasons for a company’s stock to trade at a huge discount as compared to the market value include:
- The company might be reporting a consistent loss which is eroding shareholder’s wealth and confidence.
- The market might believe that the asset value of the company is overvalued.
- The investor confidence might have diminished owing to internal/external problems of the company.
How to Use “Price – to – Book” Ratio for Value Investing?
Ratios like ROE and P/B interact in very interesting ways and ROE is a wonderful companion ratio for P/B. Return on equity (ROE) measures the amount of net income earned in comparison to total shareholder’s equity. A value investor should not get tempted if a stock with a low P/B ratio is identified. ROE is paired with P/B to get a clearer picture.
Generally, a high ROE is accompanied by a growing P/B as investors expect book value per share to grow with increasing ROE which will further bid up the market price of the company. So, if company has high P/B ratio and relatively low ROE, it would ultimately shrink the share price. Given two otherwise similar companies, the one with a higher ROE will be have a higher P/B ratio. Therefore, stocks with low ROE and high P/B should be avoided.
Limitation of Price – to – Book Ratio
Price to Book value ratio is a widely used financial metric for relative valuation however it has some shortcomings as compared to other ratios.
- P/B is useful for comparing only capital-intensive businesses like large manufacturing firms which have huge assets and it does not consider intangibles like brand name, goodwill and patents which sometimes are capable of generating huge value.
- Another limitation of P/B ratio is that it never takes into account difference in capital structure. In such scenarios, EV/EBITDA multiple is used as the valuation ratio as it is not influenced by the corporate structure of the company.
- P/B ratio can also get affected by some non-operational issues of the company as these situations can affect book value to such an extent that it would not reflect the real value of its assets.
- Book value does not provide a true picture of the companies that entails excessive debt levels and sustained losses. High debt levels can inflate company’s liabilities to the point where it can substantially offset book value of its hard assets, thereby artificially creating a high P/B ratio that understate value of its assets. Also, for companies with series of losses can generate a negative book value and therefore becomes meaningless.
Despite certain limitations, Price-Book value ratio is one of the most significant valuation ratios used by value investors for making investment decisions. It offers an effective way of identifying if the stock is overvalued and undervalued. Also, P/B ratio can be applied in situations when P/E cannot, like when the earnings of the company are negative.
Each ratio has its own set of advantages and limitations, therefore, a complete understanding of all ratios and consideration of all fundamental parameters is paramount for making a profitable investment decision