One of the popular financial ratio utilized for stock evaluation is the P/E ratio which gives investor an idea about the growth potential of the stock as this takes into account the markets expectation of the firms earning power. However, the significance of Price to Book Value ratio as an assessment tool is highly underestimated as this ratio is considered to be backward looking in its approach although the relationship between price and book value is very intriguing. Considering this, need arises to understand the components of this ratio together with its application for investment analysis.
Book Value of Equity is the theoretical value of what a company’s net assets are worth. It is mainly the difference between the book value of assets and the book value of liabilities, which is largely determined by accounting conventions. Book value of assets is the original price paid for the assets deducting any allowable depreciation on the assets. Similarly, book value of liabilities reflects the “at-issue” values of the liabilities. Since the book value is recorded at original cost, it differs from market value as the earning power of the asset is not taken into account.
Despite this fact, P/B ratio is very useful in investment analysis as it provides a much simpler benchmark for comparison because companies in similar industry follow consistent accounting standards across firms which makes the P/B ratio quite useful tool for comparison as it provides a sign for over valuation or under valuation. Generally stocks selling below the book value of equity are considered to be undervalued while those selling above the book price are considered to be overvalued. Therefore, this ratio is widely used by
Value Investors” for stocks assessment as they constantly hunt for undervalued securities for their portfolio addition. Sometimes this ratio is also utilized by companies to increase their intrinsic value per share in the market. This can be seen in the share repurchase program announced by American Capital Ltd. in 2011 where they bought millions of shares of their own stock at price reported to be below their book value per share, thereby in turn elevating the per share book value of the remaining shares. It is also useful for evaluating firms with negative earnings as those companies cannot be valued using P/E ratio.
However, caution needs to be applied while utilizing this ratio as it can often mislead investors. As book values are affected by accounting decisions on depreciation etc. and when accounting standards vary widely across firms, the P/B ratios may not be comparable. This also holds true while comparing P/B ratios across countries with different accounting standards. Also, book value is not of much use for companies holding significant intangibles assets on their Balance Sheet such as technology and services oriented firms. Hence the ratio becomes more useful while valuing the asset driven companies such as financial institutions or real estate developers. Also, one needs to be cautious enough to look through as accounts can be fudged to inflate book value, therefore conducting financial due diligence on the part of investors should also be mandatory followed. Another important thing to look for is contingent liabilities, which are generally represented as footnotes to Balance Sheet. There might be a case where company would be facing some litigation issues hence a one off payment might arise in future eroding the assets value.
Hence, as past is always not an accurate indication of future, therefore investors need to consider things such as nature of assets and liabilities, whether the company is currently making profits or losses, ratio of liabilities to equity etc. coupled with the economic indicators for the particular sector. However, if an investor utilizes both i.e. takes a glance on past coupled with an eye on the future, he should be able to identify profitable investment opportunities as buying companies below tangible book value limits downside risks and provides a safety margin.