Profits, debt and assets are the building blocks of any public company’s financial statements. For disclosure purposes, the companies break these three elements down into more precise numbers that investors can review. Investors can calculate valuation ratios from these to help compare companies. Of these, book value and price-to-book ratio (P/B ratio) are must-haves for value investors. But does book value deserve all the fanfare? Keep reading to find out.
Key points to remember
- The book value of a business is the difference in value between the total assets and the total liabilities of that business on its balance sheet.
- Value investors use the price-to-book (P/B) ratio to compare a company’s market capitalization to its book value to identify potentially overvalued and undervalued stocks.
- Traditionally, a P/B of less than 1.0 is considered a good value, but identifying a “good” P/B ratio can be difficult as it can vary by industry and a particular company may have issues. underlying financials.
What is book value?
Book value is the amount obtained by adding a company’s tangible assets (such as stocks, bonds, inventory, manufacturing equipment, real estate, etc.) and subtracting its liabilities. In theory, book value should include everything down to pencils and staples used by employees, but for the sake of simplicity, companies typically only include significant assets that are easily quantifiable.
Companies with lots of machinery, like railroads, or lots of financial instruments, like banks, tend to have high book values. In contrast, video game companies, fashion designers, or trading companies may have little or no book value because they are only as good as the people who work there. Book value isn’t very helpful in the latter case, but for companies with strong assets, it’s often the #1 number for investors.
A simple calculation dividing the company’s current stock price by its reported book value per share gives you the P/E ratio. If a P/E ratio is less than one, the shares are selling for less than the value of the company’s assets. This means that in the worst scenario of bankruptcy, the assets of the business will be sold and the investor will still make a profit.
A price-to-book ratio below 1.0 generally indicates an undervalued stock, although some value investors may set different thresholds, such as below 3.0.
Failing bankruptcy, other investors would ideally see that the book value was worth more than the stock and would also buy, driving the price up to match the book value. That said, this approach has many flaws that can trap a careless investor.
Value game or value trap?
If it’s obvious that a company is trading at a price lower than its book value, you have to wonder why other investors haven’t noticed it and brought the price down to book value or even higher. The P/E ratio is an easy calculation, and it’s published in stock summaries on any major stock research website.
The answer could be that the market is hitting the company unfairly, but it is just as likely that the reported book value does not represent the true value of the assets. Companies count their assets in different ways in different industries, and sometimes even within the same industry. This blurs the book value, creating as many value traps as it does value opportunities.
Misleading depreciation and book value
You need to know how aggressively a company has written down its assets. This involves looking back over several years of financial statements. If quality assets have depreciated faster than their true market value has fallen, you’ve found hidden value that could help sustain the stock price going forward. If the assets depreciate more slowly than the fall in market value, the book value will be higher than the actual value, creating a value trap for investors who only look at the P/B ratio.
Manufacturing companies provide a good example of how depreciation can affect book value. These companies have to pay huge sums of money for their equipment, but the resale value of the equipment usually declines faster than a company is required to write it off under accounting rules. As equipment becomes obsolete, it approaches uselessness.
With book value, it doesn’t matter what companies paid for the equipment. Only the price at which they can sell it matters. If book value is based largely on equipment, rather than something that doesn’t depreciate quickly (oil, land, etc.), it’s essential that you look beyond the ratio and into the components. Even when assets are financial in nature and not subject to depreciation manipulations, mark-to-market (MTM) rules can result in overvalued book values in bull markets and undervalued values in down markets. bear markets.
Loans, Liens and Lies in Book Value
An investor seeking to play book value should be aware of any asset claims, particularly if the company is a candidate for bankruptcy. Usually the links between assets and liabilities are clear, but sometimes this information can be minimized or hidden in footnotes. Like a person getting a car loan using their home as collateral, a business can use valuable assets to secure loans when it gets into financial trouble.
In this case, the value of the assets must be reduced by the amount of the secured loans linked to them. This is especially important for bankruptcy candidates, as the book value may be the only thing that matters to the business. So you can’t expect strong earnings to lift the stock price when the book value turns out to be inflated.
Companies suitable for book value games
Book value critics are quick to point out that it has become difficult to find true book value plays in the heavily-analyzed US stock market. Oddly enough, this has been a constant refrain heard since the 1950s, but value investors continue to find book value plays.
Companies with hidden values share certain characteristics:
- They are old. Older companies have generally had enough time for assets such as real estate to appreciate significantly.
- They are tall. Large companies with international operations, and therefore international assets, can create book value through the growth in prices of foreign land or other foreign assets.
- They are ugly. The third class of buying at book value is ugly companies doing something dirty or boring. The value of lumber, gravel, and oil rises with inflation, but many investors overlook these asset plays because companies lack the sparkle and flash of growth stocks.
Receipt of book value
Even if you have found a business that has real hidden value without any claim to it, you have to wait for the market to come to the same conclusion before you can sell at a profit. Corporate looters or activist shareholders with large stakes can speed up the process, but an investor can’t always count on insider help. For this reason, buying on book value alone can actually result in a loss, even if you’re right!
If a company is selling 15% below book value, but it takes several years for the price to catch up, then you might have done better with a 5% bond. The low-risk bond would have similar results over the same period.
Ideally, the price difference will be noticed much faster, but there is too much uncertainty in guessing how long it will take the market to realize a book value error, and this should be considered a risk.
That said, a deeper analysis of book value will give you a better understanding of the business. In some cases, a company will use excess profits to update equipment rather than pay dividends or expand operations. While this drop in profits may depress the value of the business in the short term, it creates book value in the long term because the business equipment is worth more and the costs have already been discounted.
On the other hand, if a company with obsolete equipment has consistently postponed repairs, those repairs will reduce profits at a later date. This tells you something about the book value as well as the character of the company and its management. You won’t get this information from the P/B ratio, but it’s one of the main benefits of digging into book value numbers and it’s well worth the effort.
Shopping at book value is no easier than other types of investing; it just involves a different kind of research. The best strategy is to make book value part of what you’re looking for. You shouldn’t judge a book by its cover, and you shouldn’t judge a company by the hedge it puts on its book value.
In theory, a low price-to-book ratio means you have some protection against poor performance. In practice, it is much less secure. Obsolete equipment may still add to book value, while property appreciation may not be included. If you plan to invest based on book value, you need to know the true condition of those assets.