Is Price to Book Value obsolete?

Price Book Value is a financial metric used for company valuation, that relates the equity value of a firm (e.g. market capitalization) which its book value. The book value is the carrying value of the assets in the balance sheet.

Just the same as with the Price Earnings, Price to Book Value may be calculated considering the whole company or on a per share basis, yielding the same relation (ratio) in both:

• In the first, the market capitalization divided by the total book value of equity (total assets net of depreciation minus liabilities).
• In the second, it’s the stock price divided by the book value per share, which yields the same number as the former.

At its core, the ratio means how much you pay for every net dollar on the balance sheet. In principle, the lower, the better. The book value may be seen as a far-fetched proxy of liquidating value. How much would you get if the company where to liquidate its assets today, pay its creditors; what would remain.

Of course, book value isn’t necessarily the same as liquidating value. Cash equivalents may be much closer of liquidating value than say, fixed assets. Both in the time it may be required to sale them, and in the difference between current market value and book value. Additionally, actual intangible assets may or may not be worth a lot more than stated in the accounting books, for different reasons.

Benjamin Graham used to teach about different ratios one may use when estimating the different liquidating factors of the different assets. For example, cash may be computed at 100%, while inventories maybe at 70% of carrying value, fixed asset roughly 40%, intangible at zero (it could be worthless if the firm is facing bankruptcy on a failed business), etc. But those factors aren’t carved in stone and should be reviewed for each company! As a rule, the more specific the assets (think of a very specific drilling equipment) the lower the proportionate resell value may be.

Sometimes differences between book value and market value arise due to accounting principles. For example, under US GAAP research and development must be expensed, but if successful, it could provide for better cash flows in the future. Therefore, prospects may be improving, while none of that’s reflected in equity book value. Brand value, depending on how it’s acquired, may or may not reflect on the stock book value, creating further discrepancies.

As an alternative basis, Price to Tangible Book Value (PTBV) may be calculated, by netting the Intangible assets from the book value, reaching therefore a more acid (conservative) measure. The rationale behind this, is that intangible assets could be worth nothing if the company is to be liquidated in financial distress (think of goodwill and other intangible assets).

For example, intangible assets write-offs on lower business prospects (which may or may not have been already computed in the stock price) would change the PBV of the stock, but not the TPBV.

Price to Book Value (PBV) varies greatly between industries. Say, high capital needs companies (think of an airline, a sea shipping company, an oil extracting firm, or a utility) usually trade at lower ratios than companies from low capital investment needs industries (think of a software development company which uses mostly grey matter, or an advertising agency). The higher the need for reinvestment, the lower the available free funds to reward stockholders. This metric gains relevancy for industries in which assets are very important regarding genuine fund generation, while loses when accounting assets are not that important.

But also PBV varies greatly from firm to firm, even for companies in the same industry. Why is that? Because there’re other factors taking place.

One of them is the profitability of the company. If the company earns a big deal for the net assets invested, then a high PBV is expected. While if the return on investment is lower, a PBV is usually to be expected. For those of you that like to do the math, you may discover the relationship between the PBV and PE ratios by checking that multiplying PBV times the inverse of the ROE (like Return on Equity but swapping numerator and denominator) yields the PE (Price to Earnings).

There’re more subtle factors that also take place, for example share repurchases. When a company repurchases its shares, it effectively rewards cash to its investors while reducing the equity base. From an accounting point of view, the company “shrinks” itself, returning capital to the owners. Companies that regularly buyback its shares usually display a much higher PBV than they would otherwise. In this sense, high PBV may mean a disciplined past focus on rewarding investors, a desirable trait, and not to be frown upon. This is just another example of an otherwise good metric that if read solely on its own may penalize usually what’s regarded as good behavior.

PBV is often used as a floor valuation metric. If the market capitalization of the firm is much lower than the net liquidating value, the firm is most likely undervalued. Low PTBV companies could be a good starting point in a screener as a rough proxy of liquidating value. During Benjamin Graham’s time, there used to be companies trading below the adjusted working capital, but now it’s really rare.

Many of the criticisms of the Price to Earnings ratio may be applied to the PBV. For example, neither growth nor risks are taken into account in the ratio.

PBV could be a useful metric, especially when comparing companies from the same industry, or when making rough estimations of company value.

Price to Book Value summary (TL;DR)

Price to Book Value is not obsolete, is a useful metric for company valuation. Knowing when to use it, and when and why might be distorted may give a you a better insight on a company profile.

• May be used to roughly estimate company value.
• It may be used even if the company is currently reporting losses (or negative cash flows).
• It may be particularly useful when comparing companies from the same industry, with similar capital needs.
• It may prove more stable and less procyclical in company valuation than Price Earnings (PE), which is heavily influenced by a single year results.

• Sometimes it works more like a floor metric than a valuation one.
• Many important factors on company valuation are left out of the metric.
• Net liquidating value may well be very different than accounting values.
• It could penalize companies solely on accounting principles, for example those than invest heavily in current research and development, or that try to reward investors through periodic share buybacks.