How to apply the valuation tool, and when it is most useful
Thursday 17 Oct 2019 Author: Steven Frazer

It has long been a vital tool in helping investors to value shares but price-to-book value (PBV) has fallen out of favour in recent years.

For most of the past decade investors have been drawn to growth stocks because that’s where the best returns have been earned.

The PBV value tool is not always suited to rapidly growing business, but it is much better at flagging up value, which may be coming back into fashion after a decade in the investment shadows.

At the simplest level, a company is worth the value of its assets minus its liabilities – its book value. Book value is the amount of money that would be available to shareholders if the company’s assets were sold at their balance sheet value and all liabilities were paid off.

For example, if assets equal £100m while liabilities are £60m then the company’s book value  is £40m.

Book value, also known as net asset value, is often expressed in per share terms, or book value divided by the number of shares in issue.

The market price per share is then compared to the book value per share, a figure called the PBV ratio. This is worked out by dividing the share price by the book value per share.

This is often a first point of call when looking for potentially underappreciated stocks, and especially takeover targets. If the market value of a company, or its share price, is lower than its book value, or book value per share then, in theory, a buyer could take control, and sell the company’s assets for more than it paid. This was a key theme during the heyday of the asset-strippers in 1970s and 1980s.

Investors and analysts use this comparison to differentiate between the true value of a publicly traded company and investor speculation.

As a rule of thumb, investors will infer a PBV of less than one to indicate that a stock is undervalued, while a ratio of greater than one may indicate that a stock is overvalued.

THEORY IN TO PRACTICE

Let’s look at an example, one we’ll call ABC plc. There are a couple ways to calculate book value, depending on the company. For purposes of this example, we’ll assume that the best measure of book value is total assets minus total liabilities. We’ll also assume that ABC’s shares are currently trading at 600p and there are 100 shares in issue.

ABC’s balance sheet looks like this table:

A major drawback with book value is that it is not always easy to establish the value of a company’s assets accurately. It may be unrealistic to assume that the value of an asset on the balance sheet equivalent the value it would fetch if it were to be sold off. It may be that an asset is no longer a useful to the business as it used to be, such as an old paper mill.

Equally, the value of an asset acquired in the past may have significantly increased. Property companies are a good example, where land and buildings typically sit on a balance sheet at cost yet years later may be worth substantially more, especially when property is often revalued only periodically.

Things like land, property, machinery, furniture are called tangible assets. In other words, they can be seen and touched. But not all assets can. Intangibles include more esoteric yet no less valuable entities like software, apps, brand names, corporate reputation and much else including goodwill on acquisitions. The latter effectively reflects the premium paid by an acquirer to complete most deals.

Intangible assets are another elephant in the book value room because they are often tricky to value accurately. This problem has been compounded in recent years by the fact that far higher value has been placed on intangible assets than in the past.

For example, many technology companies can trade at a PBV of 10 or more, while banks will mostly trade around 1. What accounts for this massive difference is largely how an industry uses capital to generate earnings. Technology firms do not use much physical capital to create earnings.

A perfect example is Microsoft, which is mainly a software company. Microsoft’s key costs are staff, human capital that creates earnings – the business model is not capital intensive.

On the other hand, banks require a lot of capital, such as bank deposits, bonds and so on. Because banks tend to hold relatively liquid assets on their balance sheets, these assets can be valued at their fair market value.

This means that a bank’s balance sheet, or the PBV, should be roughly equal to the fair market value of its assets, or one, whereas Microsoft currently trades on PBV of 8.3, based on Reuters’ data.

The price-to-book ratio indicates whether or not a company’s asset value is comparable to the market price of its shares. For this reason, it can be useful for finding value stocks.

It is especially useful when valuing companies that are composed of mostly liquid assets, such as in finance, investment, insurance, and banking and, bearing in mind what we said earlier about revaluation, some property companies and housebuilders.

The PBV is not as useful for firms with large research and development expenditures or so-called asset-light digital economy businesses.

Like most ratios, it’s best to compare PBV within individual sectors rather than across different industries.

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