How good is P/B multiple

I’ve seen some market commentators yelling: “Wow, this stock is trading below book value!”.

What is book value? It is the shareholders’ funds that appears in the liability side of the balance sheet. In short, it is the residual amount left after deducting liabilities of the company from the assets.

That’s the theory part. But, what does book value mean to an investor?

It means almost nothing! Well, ‘almost’ nothing..

Why? Think about it. Book value of equity will make sense only when the assets and liabilities in the balance sheet are stated at market values. In such a case, book value of equity means the net claim by the shareholders on the company’s assets. Else, it’s just a number that means almost nothing. Look at the below hypothetical balance sheet of a manufacturing company:

All amounts below are stated in USD billion:

Untitled

Let me give some more details about those balance sheet items:

Goodwill and intangibles: These came into the balance sheet as a result of past acquisitions.

Fixed assets: Most assets are very old. But the company’s real estate is worth USD 30 billion, but it is appearing in the balance sheet at USD 100 million. For the rest of the assets, the market value is USD 5 billion, as the technology of the manufacturing plant is quite old.

Earnings: The company has been making losses for the past 10 years. The company does not foresee making profits in the near future, as it has high cost of operations due to old technology, and need to raise a lot of money to modernise.

Book value per share: There are 4 billion shares outstanding, and hence book value per share is USD 10.

Share price: The market value of the share is USD 5. This translates to a P/B multiple of just 0.5x.

Now, the naive value investor notices the stock. He is mesmerised. Oh man! The stock is trading at just 0.5x P/B! Historically, it has been 2x, but now, it is just 0.5x – he sees an opportunity to quadruple his money.

Now, think about it. First of all, the company is not profitable, and does not expect to be so unless its entire machinery is modernised. Secondly, if the market value of assets and liabilities are considered, the company may well be having negative equity if we take net asset value. So, book value of equity does not show anything.

But BV does make sense for some businesses – for example, in banking and other financial services. Let’s look at banking.

Bank Bal sheet

First,look at the asset side. Notice that most assets are close to market values – Cash, deposits, investments and loans. Secondly, look at the liability side – they too are close to book values. Hence the shareholders’ equity – which is essentially the balancing figure – represents the net asset value at close to market prices. This makes P/B ratio, the most suited to valuing banks and financial institutions.

Next time somebody quotes P/B while talking on non-financial stocks, ignore them.

And next time somebody quotes P/E while talking about financial stocks, ignore them too.

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