The Importance of Book Value
by Charles Rotblut, CFA
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:
In this article
Share this article
Facebook
Twitter
E-mail
SeekingAlpha
Stumbleupon
Delicious
LinkedIn
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.
To read more, please become an AAII Registered User or CLICK HERE.
Discussion
Can someone tell me what a good rule of thumb is for max/min share price to book value?
Thanks
cssjrice@bellsouth.net
posted about 1 year ago by Cyril from North Carolina
Cyril - Regarding book value, I consider price-to-book multiples above 4 to be excessive. My preference is that the price-to-book ratio be below 2.0, though I will accept a higher price/book ratio if the company is well-managed and is financially sound. I'd rather pay a little more for a good company, then buy a stock just because its valuation appears low. Price-to-book ratios that are near or below 1.0 can be indicative of a good bargain, but you need to fully research the company. Make sure it is profitable, generates cash, well-run, financially sound, has a history of growth and is reasonably expected to grow earnings in the future. Some companies have low valuations because they are not well-run and/or their future profitability is questionable. Therefore, while there is no minimum price-to-book ratio, you want to do a thorough analysis of the stock.--Charles Rotblut
posted about 1 year ago by Charles from Illinois
Great article, thanks for explaining the details of price-to-book ratio so clearly.
posted about 1 year ago by Daniel from Alabama
Good reminder,and basically so logical, perhaps more obvious to those AAii members who ran their own businesses (or run)
posted about 1 year ago by Andrew from Illinois
"No quality company should sell for a price equivalent to or less than its theoretical liquidation value." Does that mean that any company selling at a P/B<1 is a bargain , or is no good? Also, the P/B ratio is not static, it changes over time. So, if the company's P/B ratio is momentarily <1, would that mean that it is a dog for ever? Might this statistic be useful for trading, buying a stock when the P/B ratio is lower than, say 1, and selling when it is higher?
Thanks.
posted about 1 year ago by Fernando from Florida
Fernando, it depends on the company. Take a look at the financial statements and the business model. If the company doesn't have too much debt, generates positive cash flow, is both currently profitable and likely stay profitable, and should grow profits in the future, then it is a bargain at a very low price-to-book ratio. -Charles Rotblut
posted about 1 year ago by Charles from Illinois
Excellent article Charles. I do have a couple of questions. Frequently I find that companies that sell at a low price to book value ratio have a lot of Goodwill and Intangible Assets. These assets frequently have little or no liquidation value. When determining book value do you make adjustments for assets like these? What about Fixed Assets? Some companies have a large percentage of equity tied up in machinery and equipment. This equipment may have little or no value if it needs to be liquidated.
posted about 1 year ago by Ed from Washington
Great article, thanks for explaining the pro and con aspects. I include this factor in analysis of a stock for purchase or to sell in addition to the evaluation included in SMART -1 discribed in website lifetimestrategies2009.com
posted about 1 year ago by Vern from California
Edward, I do look at intangibles in proportion to shareholder equity. My preference is to see monetary or tangible assets equating to a large part of shareholder equity. It does depend on the company, however (e.g., The name "Coca-Cola" has significant value.) Fixed-assets are tougher, because there can be buyers, especially for equipment such as CNC machines. I've always just used the recorded value, because any other number would be a guess on my part. The same types of dilemmas exist with accounts receivables and inventory, which is why I describe investing as messy, instead of exact. -Charles Rotblut
posted about 1 year ago by Charles from Illinois
I am disappointed that there was no mention of the fact that stocks that trade around book value normally have low ROE's. Looking at a universe of stocks that say have ROE's of 15-25% you will find all of them at a 2-5 times book. On the otherhand if you look at stocks at the 3-7% ROE range , you'll see the price around book value or less. The ROE determines how a price is in relation to bkk...same as the profit margin vs. price to sale ratio.....the higher the margin the higher the psr etc..
posted about 1 year ago by Alan from Pennsylvania
