How to Use the P
Post on: 23 Август, 2015 No Comment
The price-to-book (P/B) ratio is widely associated with value investing, and in fact we use it as one of the metrics on our Motley Fool Inside Value scorecard. Like the price-to-earnings (P/E) ratio. a low P/B ratio isn’t always indicative of an undervalued company. Conversely, companies with a relatively high P/B ratio are not necessarily overvalued. P/B is a useful measure for comparing firms that have negative earning; those businesses can’t be compared using the P/E ratio. Quite simply, far fewer firms have negative book values.
The P/B ratio is calculated as follows:
P/B ratio = market capitalization / book value of equity
(Market capitalization is often abbreviated as market cap; book value is often abbreviated as BV)
Market capitalization = shares outstanding * market price per share
Book value of equity = book value of assets — book value of liabilities
So therefore, P/B = market cap / (BV of assets — BV of liabilities)
The book values of assets and liabilities are easily found on the balance sheet. The book value of assets is usually classified as total assets. You may need to do some arithmetic to arrive at the book value of liabilities (it may not be quite so obvious on some balance sheets), but it includes all current liabilities and long-term obligations. The book value of equity is often broken out for us under the heading Shareholders or Shareowners Equity. In my experience, most financial websites are fairly accurate with P/B ratios.
What we can deduce from a low P/B
In absolute terms, a P/B ratio under 1.0 is considered low (there are some variations that I’ll explain later). Generally speaking, a low P/B can indicate:
- That assets are overstated on the balance sheet. In this case, we should avoid the company because it may be destroying shareholder value. Ford ( NYSE: F ) is a good example of this. According to MSN Money Central, Ford’s P/B was 0.72 in 1997, and its book value per share was $25.54. Today, Ford’s P/B is 1.30, and its book value per share is down to $7.66. During that time, the share price has fallen from nearly $50 to less than $10. Clearly, Ford had other problems, but the low P/B certainly did not indicate value. At Inside Value. we generally look for companies that have been increasing book-value-per-share over a number of years because — as Ford’s plight shows — the share price often follows the book value per share.
P/B has a buddy
ROE is a useful companion metric for P/B. This is no surprise; after all, the B in P/B and the E in ROE are one and the same — they’re both symbols for b ook value of e quity.
A high ROE normally accompanies a high P/B ratio because investors naturally bid up the price of a company that gives them a better return on their equity. Similarly, companies that have high earnings growth rates generally have high P/B ratios — investors expect the book value of equity per share to grow.
However, if a high-growth company has a high P/B ratio and low ROE, that growth may not be translating into shareholder value. This could portend a collapse in share price.
Even if growth rates are average, a company with a high ROE will generally have a high P/B ratio. Consequently, I always screen for ROE and P/B. The difference between the company’s ROE and its cost of capital is important. The wider the spread, the higher the P/B ratio (the higher it should be, at least). Even when comparing P/B within an industry, there may be discrepancies that have nothing to do with valuation.
Best use of P/B
P/B is best used for asset-heavy companies, such as financial institutions, manufacturing companies, and other capital-intensive industries. Companies with a regular inflow of new assets, such as capital expenditures in the case of DaimlerChrysler ( NYSE: DCX ) or more cash in the case of JPMorgan Chase ( NYSE: JPM ). are likely to have book values that at least relate to market values (e.g. at around 1.2 for the P/Bs of Daimler Chrysler and JPMorgan). In both cases, a lower-than-average P/B ratio compared with past years may indicate a value opportunity. Comparing it to the S&P 500 average P/B of 2.84 (according to Barra) is meaningless as a measure of value.
P/B distortions
Distortions in P/B (and ROE, for that matter) arise because book value of equity is more an accounting measure than an economic measure. Here are a few natural distortions to watch out for:
- Companies that have very long-lived assets (like real estate) still on the balance sheet at original cost (i.e. the book value) will have understated assets and, therefore, an understated book value (remember, book value of equity = assets — liabilities). All other things equal, the effect will be an increase in the P/B ratio, as the reported B is lower than the real value of the equity. In this case, you might miss an undervalued company by simply looking for low P/B ratios.
Foolish final thoughts
That’s just a brief look at the P/B ratio, and I’ve only touched on a few of the wrinkles associated with it. P/B is a very useful measure of value, but as with other valuation metrics, it should not be used in isolation.
Philip Durell heads up the Fool’s Inside Value newsletter service. To date, his picks are outperforming the S&P 500 by a margin of 4.43% to 0.20%. If you’d like to join Philip on the search for undervalued stock opportunities, you can sample his service for 30 days for free. There is no obligation to subscribe.
Philip Durell does not own shares of any company mentioned in this article. JPMorgan Chase is a Motley Fool Income Investor recommendation. The Motley Fool has a disclosure policy .