Price To Book Value Ratio

P/BV is a valuation ratio and is arrived at by dividing the market price of a share with the respective company’s book value per share. Now, book value is equal to the shareholder’s equity (share capital plus reserves and surplus). Book value can also be arrived at by subtracting current liabilities and debt from total assets. For the banking and finance companies, book value is calculated as ‘share capital plus reserves minus miscellaneous assets not written off. This formula then takes care of the bank’s NPAs and gives a correct picture.

P/BV figures for companies in the services industries like software and FMCG are high as compared to those of companies in the sectors like auto, engineering, steel and banking. This is because companies from the sectors like software and FMCG have low amount of tangible assets (fixed assets etc.) on their books and, as such, the P/BV may not be a correct indicator of valuation. On the other hand, old economy sectors like auto and engineering have large balance sheets, i.e., they have a large amount of fixed assets and investments. As such, P/BV is a good indicator of measuring value of stocks from these sectors.

What does P/BV indicate?

P/BV is a good metric to value stocks of companies in the capital-intensive industries like engineering, automobiles and banks, which have large amount of tangible assets in their books (balance sheet).

If a company is trading at a P/BV of less than 1, this indicates any or both of the two:

1. Investors believe that the company’s assets are overvalued, or
2. The company is earning a poor return on its assets.

A high P/BV indicates vice versa, i.e., markets believe the company’s assets to be undervalued or that the company is earning and is expected to earn in the future a high return on its assets.

Book value also has a relationship with the ‘Return on Equity’ of a company. In fact, book value can also be termed as equity (equity capital plus reserves and surplus). As such, for a company that earns a high return on equity, investors would be ready to give the stock a high P/BV multiple.

P/ BV indicates the inherent value of a company and is a measure of the price that investors are ready to pay for a ‘nil’ growth of the company. As such, since companies in the services sectors like software and FMCG have a high growth component attached to them, P/E and not P/BV is a right measure of their valuations . P /BV should not be used for valuing companies with high amount of debts. This is because high debt marginalizes the value of a company’s assets and, as such, P/BV can be misleading.

A low price to book value ratio need not necessarily be a signal to invest in a stock. Book value normally indicates the net depreciated value of assets after deducting the value of outstanding liabilities. In other words, it indicates the book value of the shareholders’ combined stake in the business. Though this is easily comparable to the share price, it is not an accurate measure of the intrinsic value of an enterprise as it is too bookish.

The book value does not take into account the operational inefficiencies or obsolescence of the plant and equipment. It also does not factor in the true value of real estate the company owns, the realisable value of these assets or their income generation capabilities. Besides, intangibles such as brand value, patents and intellectual capital are not accounted for.

Thus, though it provides a broad indication of shareholder value, it cannot form the sole basis for investing in a company.

Source: Equitymaster