The Importance of Book Value
Multiple studies have shown that price to book value (P/B) is the most effective valuation measure in determining a stock’s performance. Although the price-earnings ratio (P/E) is considerably more popular, buying at low price-to-book multiples leads to better returns.
Book value is the theoretical value of what a company’s net assets are worth. It is also referred to as equity. In theory, book value is equivalent to the amount of cash shareholders would receive if all of the company’s debts, both short-term and long-term, were paid off and all remaining assets were sold. Its compelling use as a measure of valuation can be explained in one statement:
No quality company should sell for a price equivalent to or less than its theoretical liquidation value.
Remembering and constantly applying this statement will do more to help you make money than just about any other investment concept. Benjamin Graham encouraged investors to look for companies trading near or below their book values in his 1934 classic “Securities Analysis.” More than 75 years later, buying stocks trading at low price-to-book multiples (share price divided by book value per share) continues to work.
The reason why book value is such a powerful measure of valuation lies deep in the concept of what book value is and what it means to an ongoing business concern. Book value is what a company’s net assets are worth. A price-to-book multiple of 1.0 means the company is worth the same as its net assets. This multiple means the market is indifferent as to whether the company opens its doors tomorrow. If the business is shut down, the debts paid off and the assets liquidated, shareholders’ wealth will, theoretically, be unchanged. If the company stays open, shareholders’ wealth may increase or decrease—not liquidating the company essentially becomes a roll of the dice.
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