by Charles Rotblut, CFA

Multiple studies have shown that price to book value (P/B) is the most effective valuation measure in determining a stocks performance. Although the price-earnings ratio (P/E) is considerably more popular, buying at low price-to-book multiples leads to better returns.

Book value is the theoretical value of what a companys net assets are worth. It is also referred to as equity. In theory, book value is equivalent to the amount of cash shareholders would receive if all of the companys debts, both short-term and long-term, were paid off and all remaining assets were sold. Its compelling use as a measure of valuation can be explained in one statement:

No quality company should sell for a price equivalent to or less than its theoretical liquidation value.

Remembering and constantly applying this statement will do more to help you make money than just about any other investment concept. Benjamin Graham encouraged investors to look for companies trading near or below their book values in his 1934 classic Securities Analysis. More than 75 years later, buying stocks trading at low price-to-book multiples (share price divided by book value per share) continues to work.

The reason why book value is such a powerful measure of valuation lies deep in the concept of what book value is and what it means to an ongoing business concern. Book value is what a companys net assets are worth. A price-to-book multiple of 1.0 means the company is worth the same as its net assets. This multiple means the market is indifferent as to whether the company opens its doors tomorrow. If the business is shut down, the debts paid off and the assets liquidated, shareholders wealth will, theoretically, be unchanged. If the company stays open, shareholders wealth may increase or decreasenot liquidating the company essentially becomes a roll of the dice.

Such a view is admittedly callous. Workers depend on the company staying open to continue collecting their salaries. Suppliers will lose business if the company closes and customers will be forced to find another vendor and either potentially pay higher prices or get a lower quality product, or both. However, the market is apathetic as to whether or not a business opens it doors tomorrow. Stocks are bought and sold for one reasonto make money. If the same amount of money can be made by liquidating the company as can be made by keeping the doors open, then where is the incentive to take the chance that the stock will be worth more tomorrow or the day after tomorrow? The market is essentially telling shareholders that the reward for keeping the company open is minimal.

In theory, shareholders should vote to liquidate any company below book value. In reality, however, a company may be worth more as a going concern than the value of its net assets. An existing company has a necessary organizational structure encompassing management, employees, accounting procedures, customers and suppliers. It has office equipment in place, such as desks, computers, phones and cabinets. It may also have machinery, tools and warehouse equipment. Intangible assets such as a brand name, a website address, a physical address and phone number(s) are established.

While this may all seem immaterial to a companys worth, these intangibles are the essence of an ongoing corporation and, therefore, add value. For instance, suppose an (extremely wealthy) investor wanted to enter the soda business. He could buy an existing soda company or he could start up his own company. If he chose the latter, he would have to acquire office space, set up bottling facilities and establish a distribution system. In addition, he would have to hire employees, create a management structure, build a customer base and promote his company. None of these even accounts for mundane activities such as purchasing office supplies, paying bills or getting phone service established.

Creating a business from scratch takes a lot of work and a lot of money. Even after much effort and capital is put into the venture, most companies fail within their first few years of operation. The money invested in a failed corporation is not the only loss; there is also the opportunity cost of not having invested the money elsewhere. Opportunity costs compound monetary losses.

The opportunity cost of investing in an ongoing concern can be lower, particularly if a good management team is in place. An existing company has a physical structure (office space, furniture, copiers, etc.), an organizational structure (a chain of management, employees, etc.) and intangibles (branding, a recognizable address, etc.). It also has procedures for acquiring necessary supplies and lines of credit. Most importantly, an established company has paying customers, distribution systems and a method for bringing new products to market. Everything necessary for a company to function is already set up and operational.

Measuring Realized Return

A mathematical argument can also be made for why an ongoing concern should not sell for near or below book value. A profitable, well-managed company will generate a return on its assets. This profit can either be maintained as cash (increasing book value), invested in new projects (potentially creating a higher stream of earnings in the future) or given back to the shareholders (dividends or stock buybacks). In any of these scenarios, shareholders may benefit more by keeping the doors open than they would by liquidating the company.

This can be demonstrated by using the return-on-equity (ROE) ratio. Return on equity is proportionate profit generated off the companys net assets. ROE is simply calculated as:

net income shareholders equity

For the purpose of presenting the mathematical argument against liquidation, lets use a fictional company with a market capitalization (share price times number of outstanding shares) of $900 million and $1 billion in shareholders equity (total assets minus total liabilities). Shares of this company trade at a price-to-book multiple of 0.9 ($900 million $1 billion). During the past five years, the company has generated an average return on equity of 10%. For the sake of simplicity, we will also assume that net income has increased proportionately to the increase in shareholders equity.

If shareholders voted to liquidate the company, they stand to gain 11% on their investment. This would be a one-time gain of $100 million dollars spread among all shareholders, whose total investment, according to the market value of the company, is $900 million.

A return of 11% may seem pretty good, but if shareholders decide to roll the dice and assume that the company will continue to be profitable and generate 10% return on equity into the foreseeable future, the potential gains are even bigger. In fact, in about two years, shareholders can get nearly double the return even if the stock continues to trade at a price-to-book multiple of 0.9. Table 1 shows the calculations.