Many famous value investors, academics and value-oriented strategies use the price-to-book-value (P/B) ratio to gauge if a stock is cheap or expensive.

Benjamin Graham popularized the indicator in his books “Security Analysis” and “The Intelligent Investor.” Nobel Prize winner Eugene Fama and his research partner Kenneth French use the ratio in their three- and five-factor models to describe stock returns. Professor Joseph Piotroski uses the ratio as the only valuation measure in his F-Score methodology, which serves as the basis for the strategy with the best long-term performance of the more than 60 stock screens tracked by AAII. The ratio is also a core component of AAII’s Model Shadow Stock approach.

The price-to-book ratio is calculated by dividing a stock’s current share price by the company’s book value per share. Book value is simply total assets less total liabilities. In other words, book value is what the net assets—meaning equity—are worth. It is the historical accounting value of a company’s residual equity. The price-to-book ratio, therefore, tells you how a stock is valued relative to a share of equity in the company it represents.

The allure of the price-to-book ratio comes from both its long-term track record of predicting future relative performance and what it ties valuation to.

Fama and French’s “The Cross-Section of Expected Stock Returns,” published in the June 1992 Journal of Finance, is among the most cited research on the performance of the price-to-book ratio in modern times. In the study, they documented significantly higher returns for portfolios of low price-to-book ratio stocks compared to portfolios of high price-to-book ratio stocks. Data published by Kenneth French on his website shows portfolios constructed of low price-to-book stocks beating portfolios of high price-to-book stocks by an average of 3.1% per year between 1927 and 2014. (French’s website is http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.)

[A quick side note: Fama and French, along with other academics, use the terminology of “book-to-market,” which is the inverse of price-to-book. The differences are that the numerator and the denominator are flipped and total book value and market capitalization are used instead of the share price and book value per share. Thus, instead of P/B, academics use B/M.

It is also not uncommon to see references to “book value” or simply “book.” A practitioner might refer to a company as trading at X times book value or X times book. Such references refer to the price-to-book ratio.]

A price-to-book ratio of 1.0 suggests the current price is equal to the proportionate amount of equity in the company a shareholder can lay claim to by owning a share of the stock. It’s an important valuation benchmark because it reveals whether or not the market is assigning a premium to a company’s net assets as consideration for the company operating as a going concern (a price-to-book ratio above 1.0) or if the market is suggesting to shareholders that they should liquidate the company (a price-to-book ratio less than 1.0).

The Value of Assets in Place

From a purely mathematical standpoint, any company trading below its book value should be liquidated. When a company’s market capitalization (total shares outstanding times the share price) is less than the amount of book value listed on the balance sheet, an arbitrage opportunity exists. Investors could buy the stock, sell all of the assets, pay off all of the company’s liabilities and have enough left over to give themselves a profit.

For example, say a company has a market capitalization of $5 billion, total assets of $15 billion and $9 billion in total liabilities. Its book value is $6 billion ($15 of assets minus $9 billion of liabilities), which would equate to a price-to-book ratio of 0.83. If shareholders were to acquire all outstanding shares at the current price, shut down operations immediately, sell all of the assets, and pay off all outstanding loans and bills, they would have $6 billion in cash (the difference between assets and liabilities) to distribute among themselves. This cash distribution would result in a realized profit of about 20% ($6 billion in cash less $5 billion market capitalization of the company divided by $5 billion).

In concept, this would seem like a logical step to take for nearly any company trading below its book value. Buy the company, liquidate it and take the profit. However, there are a few big reasons why this does not routinely happen.

First, it requires control of the company—something that is difficult for even activist investors with access to significant amounts of investment capital to achieve. Large shareholders may not be willing to part with their shares. Some shareholders (both big and small) may demand a premium to the current price to sell their shares.

Second, the accounting value of the assets and liabilities recorded on the balance sheet may significantly differ from the actual proceeds received during liquidation. Buyers will pay as little as possible for the assets. New payables would arise, such as accounting fees. Penalties for breaking leases and contracts could be assessed. Office furniture may be fully depreciated, but still has value and may sell for a higher price than its recorded value on the balance sheet. Inventory could be worthless—especially specialized parts—or could sell for considerably less than purchase price. The value of inventory may also be higher, depending on what is being sold (e.g., raw steel, widely used components that have appreciated in price since the company originally purchased them, etc.) Certain customers, knowing that the company is being liquidated, could attempt to avoid paying invoices, thus making receivables worth less. Intangible items might command a dollar value completely unrelated to what is listed on the balance sheet. (A consequence of accounting and tax rules is that the recorded value of assets and liabilities can differ—sometimes significantly—from what a willing buyer would pay or a creditor will accept.)

Third, shareholders may realize a far bigger profit if the company continues operating. Under a liquidation scenario, return on investment is singular—a one-time event. If the company keeps its doors open, shareholders have the potential to benefit from both future share price appreciation and dividends. This would particularly be the case if the company is profitable and realizes free cash flow (or soon returns to being profitable and cash flow positive).

A price-to-book ratio of 1.0 or lower does not give credit for the advantages of a business being a going concern. It dismisses the intangible value of having a trained staff, established and working facilities (offices, warehouses, plants, etc.), existing relationships with customers and suppliers, name recognition and various logistics (known contact information, distribution networks, billing systems, etc.). All of these are what separates a collection of desks, phones, computers and machinery from an actual company. When financial analysis ratios such as return on equity are used, they consider how much intangible value is being created from the company’s accounting value of its recorded assets.

If a company can reasonably be expected to be profitable and realize free cash flow in the future, it should trade at a premium to its book value. The seemingly premium cost to purchase the shares may still represent a discount to the monetary and opportunity cost of trying to start a competitive business instead. (Opportunity cost is the return that could have been realized by choosing to allocate one’s investment dollars elsewhere.)

Caveats of Using Book Value as a Valuation Measure

The price-to-book ratio relies on a company having shareholder equity. In other words, for the ratio to be calculated, a company’s assets must exceed its liabilities. The price-to-book ratio is never negative. A company with more liabilities than assets has no shareholder equity to be valued on. Rather, the bondholders and other creditors have full claim to all of the company’s assets. It is prudent for investors to avoid such stocks.

As I write this in May 2015, there are 4,710 exchange-listed stocks with a price-to-book ratio in AAII’s Stock Investor Pro fundamental stock screening and research database. In contrast, there are 3,303 exchange-listed stocks with a price-earnings ratio, 4,720 exchange-listed stocks with a price-to-sales (P/S) ratio and 2,065 exchange-listed stocks with a price-to-cash-flow (P/CF) ratio. Like the price-to-sales and the price-to-cash-flow ratio, a company does not need to be profitable to have a price-to-book ratio. Though slightly more companies have a price-to-sales ratio, it’s important to realize that a company can have no shareholder equity (book value), but have incoming revenues or have no incoming revenues, but have shareholder equity.

As noted previously, the price-to-book ratio is based on recorded accounting values. The asset values reported on the balance sheet are determined by accounting rules and may not reflect the actual price an asset can be converted into cash for. A computer monitor may be fully depreciated under accounting rules, but could sell for a certain price. A creditor may be willing to accept less than a dollar for every dollar of reported liabilities. Inventories may have turned obsolete or, in the case of a supply shortage, be worth considerably more than stated. Plus, the balance sheet is merely a snapshot of a company’s assets and liabilities on a given day (most often at the end of a quarter or year). It changes on a daily basis.

The unique capital structure of many financial firms complicates the use of price-to-book ratio as a comparative tool for assessing valuations. Fama and French purposely excluded financial firms from their analyses of the factors driving stock returns because the high leverage that is normal for these firms does not convey the same level of risk as it does for other firms. In other words, the balance sheets are not comparable because of the capital requirements financial firms must adhere to. Furthermore, financial companies do not have the same freedom to use their capital as companies in other industries do. (For example, banks are subject to regulations regarding their financial structure.) For these reasons, subsequent studies based on and strategies incorporating Fama and French’s work (including Piotroski’s research and AAII’s Model Shadow Stock Portfolio) purposely exclude financial firms.

It’s important to realize that no single measure of valuation is perfect. Book value is no different. But even with the aforementioned caveats, the price-to-book ratio has proven to be an effective measure of whether a stock is cheap or dear.

Acceptable Ranges for the Price-to-Book Ratio

There are differing opinions as to how low a price-to-book ratio investors should pay.

In their 1934 book “Security Analysis” (reprinted in 1996 by McGraw-Hill), Benjamin Graham and David Dodd advised investors to buy stocks trading below their liquidating value. This was the value of tangible assets relative to liabilities. Tangible assets exclude intangible assets, such as goodwill. Graham and Dodd also excluded all obligations ahead of common stockholders, such as reserves set aside to pay for the retirement of common stock.

Graham gave two additional ranges in his book “The Intelligent Investor.” In the final, fourth edition (Harper & Row, 1973), he advised “defensive investors” to pay no more than 1.5 times book value (which he also referred as “net asset value”) and 15 times the average earnings of the past three years. “Enterprising investors” should seek to pay no more than 1.2 times the value of net tangible assets. Graham described enterprising investors as more willing and able to devote time to the selection of securities, whereas defensive investors were described as wanting to avoid mistakes and frequent decisions.

Investment firm Tweedy, Browne argues for a similar approach to that advocated in “Security Analysis.” In their paper “What Has Worked in Investing,” the firm’s managing directors suggest looking for “stocks selling at discounts to net current assets (i.e., cash and other assets which can be turned into cash within one year, such as accounts receivable and inventory, less all liabilities).”

AAII’s Model Shadow Stock Portfolio requires stocks to be trading at less than 0.8 times book value. Slightly less than 10% of all exchange-listed stocks have price-to-book ratios at or below this number as I write this. AAII founder Jim Cloonan allows that investors following the portfolio can pay as much as 0.9 times book value, which is equivalent to the bottom 14% of all stocks. (These guidelines may change in the future depending on prevailing market conditions.)

Joseph Piotroski found that fundamentally strong stocks with low price-to-book ratios experienced higher rates of returns. His 2002 paper, “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers” is the basis for AAII’s Piotroski: High F-Score Screen. The screen requires passing stocks to have a price-to-book ratio ranking within the bottom quintile of all stocks, meaning the bottom 20%.

In an analysis of stocks with large gains, Marc Reinganum found such stocks to have an average price-to-book ratio of 0.95. His 1989 AAII Journal article, “Investment Characteristics of Stock Market Winners,” served as the basis for our Stock Market Winners screen. This strategy uses a slightly looser maximum limit of 1.5 book value (Reinganum advised setting a maximum limit of 1.0 times book value).

Others use relative measures to determine what an appropriate price-to-book ratio is, rather than setting an absolute value. Various academic studies, including the aforementioned Fama and French research, segment companies based on the percentage rank of their price-to-book valuation relative to all other companies. James O’Shaughnessy found stocks ranking in the bottom four deciles (lowest 40%) of all stocks based on price-to-book ratio outperformed all stocks between January 1, 1927, and December 31, 2009. A similar pattern holds for large-cap stocks. As I write this in early May 2015, a stock ranking in the lowest 40% of all domestically traded exchanged-listed stocks has a price-to-book ratio of 1.54 or lower.

In his book, “What Works on Wall Street” (Fourth Edition, McGraw-Hill, 2012), O’Shaughnessy says the long-term results hide periodic trends. Specifically, stocks ranking in the lowest decile—meaning having the 10% lowest price-to-book ratios—have underperformed over certain historical periods. He notes that this particularly occurred during the Great Depression and that the ultra-low valuations may have been assigned to companies in distress.

Table 1 shows the current range of price-to-book ratios for all domestically traded exchanged-listed stocks in the Stock Investor database as of May 8, 2015. The median stock currently has a price-to-book ratio of 2.04, while the average stock has a price-to-book ratio of 4.64. The difference is caused by the skewing of stocks with extremely high ratios. These are companies with minimal amounts of shareholder equity, and they most likely have very high levels of debt relative to their assets.

Table 1. Price-to-Book Ratios Over Time for All Exchanged-Listed Stocks

Table 1 also shows price-to-book ratios for all domestically traded exchanged-listed stocks at the height of the previous two bull markets and the bottom of previous two bear markets to give a historical perspective on what a high and a low median price-to-book ratio is. The median price-to-book ratio has varied considerably over time, from 0.85 right near the end of the 2007–2009 bear market in February 2009 to 2.08 in September 2007. The average price-to-book ratio has shown even greater variance, ranging from 1.93 in February 2009 to 11.47 at the end of February 2000, just before tech bubble peaked.

Table 2 shows current and historical price-to-book ratios for non-financial domestically traded exchanged-listed stocks. Financial stocks were specifically excluded because their price-to-book ratios may not be comparable with companies in other industries or sectors. Both median and average price-to-book ratios are higher when financial stocks are excluded. The one exception is February 2009, when the median price-to-book ratio was lower for the non-financial stock universe than it was for the all domestically traded exchanged-listed universe.

Table 2. Price-to-Book Ratios Over Time for Non-Financial Stocks

A breakdown of prevailing price-to-book ratios by sectors is presented in Table 3. While many sectors have median price-to-book ratios well under 3.00, conglomerates and health care are notably at the high end. Again, the price-to-book ratios for financial companies may not be comparable to those of companies in other industries and sectors.

Table 3. Price-to-Book Ratios by Sector

Pairing the Price-to-Book Ratio With Other Indicators

The low maximum limits for price-to-book ratio as a criterion reflect its appeal to value-oriented investors. The low limits also reflect the historical success of buying stocks trading near or below their net asset value and the underperformance of highly valued stocks. As Fama and French showed, low book value has historically beaten high book value over the long term.

Most value investors look beyond merely cheap stocks. They pair a low price-to-book ratio with other indicators to better ensure the stock is a bargain, as opposed to merely cheap. Cloonan requires profitability and a low price-to-sales ratio. Piotroski seeks out companies with improving financial strength. Reinganum requires earnings growth and price momentum.

O’Shaughnessy recommends paring the price-to-book ratio with other criteria to reduce the risk of the valuation indicator underperforming over a specific period of time. Among the best performers of the strategies he tested were several combining price-to-book with above median price momentum (defined as relative price strength, or how a stock has performed versus an index over a given period of time—such as three or six months—relative to all other stocks). The combination worked particularly well with small- and micro-cap companies, though O’Shaughnessy also found the strategies have performed well with his “all stock” universe.

The use of qualifying criteria in addition to a low price-to-book ratio shows the importance of not solely relying on a single indicator. While many value investors refuse to pay above a certain price-to-book ratio, they also take steps to separate stocks that are cheap for a reason from those that are bargains. Even Benjamin Graham—whose strategy Warren Buffet has described as looking for cigar butts with one puff left—advised readers of “The Intelligent Investor” to seek out companies with a history of profitability and dividend payments.

It’s also important to pair the price-to-book ratio with other measures because the balance sheet is not an accurate measure of current values, but rather an estimation using historical accounting decisions and a company’s assets and liabilities on a specified day, such as at the end of a calendar quarter. The actual value of assets and liabilities changes every business day, making a precise assessment of current value difficult. What the price-to-book ratio does do, however, is provide a good estimation of whether a stock is attractively or expensively priced, and that is why this indicator has worked very well over the long term.

Related

AAII Stock Ideas

Tweedy, Browne: “What Has Worked in Investing”

Related

Stock Strategies

The Importance of Book Value

Related

Feature

Investment Characteristics of Stock Market Winners