Price to Book Value is a ratio that compares the market price of a stock with it book value. It is an excellent tool for value investors, in that it tells us how much we are playing for every Re of book value of the company. It enables a comparison between the price at which the assets were acquired by the company, and the price it is trading at. The ratio can be used to find compare different firms on the basis of premium one is paying over the purchase price (or discount one is getting)
Book Value (BV) can be easily located in the ‘Shareholders Equity’ column of the balance sheet. It represents the money that belongs to the shareholders and includes share capital and all reserves and surpluses that belong to the shareholders. The BV may be alternatively calculated by adding all assets, and reducing all liabilities from there; however you have a direct access to that figure in the Share Capital column, so don’t have to go the roundabout way.
Let us consider an example.
Share price of a company is Rs 500.
The BV, or the shareholders’ equity is Rs 700 crores. The outstanding shares of the company are 1 crore.
Thus BV per share is Rs. 700 crores /Rs. 1 crore = Rs 700
P/BV = 500 / 700 = 0.71
What does it mean? It means for every 1 rupee of acquisition cost the company has incurred, the market is willing to pay only 71 paisa. Apparently this looks like a bargain. However, as stated before, replying on one ration can lead to erroneous conclusions; ratio should only be considered as a lead to something which may or may not turn out to be true. Quite possible, this is a bargain; the irrationality prevailing in the market might have brought the price down to a very low level, making it Benjamin Graham kind of stock. Alternatively it is also possible that the company may be a sinking ship, for example, the technology has made it possible for the new company to produce goods cheaper, and it is left with the burden of higher capital cost and obsolete technology, and for that reason the market is discounting it below its book value.
As with all other ratios, this varies considerably from industry to industry. Thus, an infrastructure company which needs to sink in substantial money in plant and machinery and other facilities will usually trade at a lower P/BV ratio than a software company. It can also be interpreted that in the case of a software company, the market expects the company to create more value with each rupee invested, and is willing to pay more premium.
Like all accounting ratios, it is important that you understand the limitations of P/BV also. We need to first understand the concept of book value from the accountant’s perspective. Transactions are recorded in the books of accounts on the basis of historical pricing. A piece of land purchased in 1892 by Britannia in Mumbai- at a time when land could be bought by acres in the villages around Mumbai(which are its suburbs now)for Rs 500 might be worth 500 crores now. But under normal circumstances, the land will be reflected in the books at Rs 500 alone. The profit will come when it is sold and might suddenly disrupt the whole balance sheet. However, till it is sold, it might look like an insignificant figure in the balance sheet. A company which has recently bought land of the size 1/10th of this land at 50 crores, will have higher book value. Take a converse case. A company which had invested Rs 100 crores in a machine to manufacture CD’s replicating machine (example, Moser Baer) suddenly finds that technology has changed, there aren’t enough people buying CD’s now. If the company decides to modernise, and sell the equipment, the old machine- though in perfect working condition, and actually in operations- may have to be sold to the junk dealer by kilos. Land appreciates in value, depreciable machinery; factory building and furniture lost their value over time. In most cases the appreciation and depreciation even out. However, one must still be cautious, when comparing a 100 years old company with a new business.
Similarly, accounting principles do not recognise the value of brand value, goodwill, and other intellectual properties, which are self generated. A company which has been in business for 50 years will command a considerable goodwill in comparison to a new business. This goodwill, generated over a long period of time has no significance to an accountant, and will not get recorded in the books of accounts. However, when a company pays actual cash or any other consideration to acquire a brand (example, Coca Cola acquiring Thumbs Up) the amount paid will be added to the asset base of the company. Thus companies that enjoy ‘economic moat’ have a great deal of hidden reserves, not visible in the balance sheet. Since they are not reflected in the BV, it gives an edge to a knowledgeable investor- the man who has the stock within his circle of competence.
The rationale in using P/BV ratio is to find out how much would be left if the company went bankrupt, and everything needed to be sold off. Benjamin Graham’s Net Net is also inspired by the same philosophy, though uses a different formula.
Except a few companies like banks and financial companies, book value has no relevance to the market value of the company. The items appearing in the balance sheet are the result of double entry book keeping, and go to the balance sheet because they did not go in the profit and loss account in that relevant year, and are thus accumulated over different periods of time, making it a potpourri of varied transactions.
P/BV does not consider the leverage: if a company is carrying heavy debt in its balance sheet, it would not be reflected in the ratio. Thus the company may look robust based on the book value, but may actually be on the verge of collapse because of debt burden.
Moreover, as discussed above, for companies like Apple, Coca Cola, and Monsanto, the book value has no relevance, the assets falling out of their balance sheet far exceed in value than those recorded in the balance sheet. In Benjamin Graham days, when intellectual properties had not much value, book value could have correlated well with the market price of a company, but as the companies matured, the book value seems to have lost its relevance, except in specific industries. That is why Warren Buffett said “In all cases, what is clear is that book value is meaningless as an indicator of value”.
In spite of the limitations, P/BV continues to be an important indicator, because it is easy to compute, the book value remains stable so it makes the comparison of the same stock over different periods meaningful, and it may be useful in situations where BV is positive but EPS is negative, because P/E ratio becomes irrelevant in such situations.
When it comes to simplicity and ease of use, this took wins hands on. It will thus continue to be used by investors as a tool for analysing companies.
©Dr. Tejinder Singh Rawal
M. Com, MA (Economics), MA (Public Administration), MA (Urdu), LLB, FCA, ISA, CISA, CISM, PhD
This content is copyrighted and no part of it may be reproduced without the consent of the author
This discussion will be a part of the forthcoming book by me “The Smart Long Term Investor: Common Sense Strategies for Wealth Creation” Suggestions are welcome and will be appreciated