by Elmads

From my previous blog of “Relative Valuation – The Price-to-Earnings Ratio”, we now move forward to looking into the general health and stability of a company, and that is the Price-to-Book Ratio.

If P/E Ratio shows the relationship of the company’s stock price to its earnings, the P/B Ratios on the other hand convey the relationship of stock market price to its equity.

Remember that the Balance sheet is the reflection of a company’s health, It consists of Assets, Liabilities and Equities, which are the main drivers of the business operations. I have discussed this in a deeper sense in my blog titled “The Balance sheet”, which I also explained how to understand each data on it.

Generally speaking, the asset of a company is the main driver of the business, it consists of liquid cash, short-term and long-term invested cash, the inventory which the company sells to gain profits and the property, plant & equipment which the company uses for their day to day operations.

Nevertheless, most companies do not completely own most of the assets, because some of it was acquired by spending money that they borrowed from others, which is basically debt. That is why in every balance sheet there will always be Assets and Liabilities. When you subtract all of the assets of the companies from its debt obligation/Liabilities, what we get is the Equity.

To make it more complicated, equity comes into the picture. Equity is the degree of ownership of the owners of the company . There will always be an owner or group of owners in each and every company in the world, which is an absolute fact. What do the owners own in the company? it is all of its Assets MINUS all of its Liabilities, which is then the net equity, or also called “the Shareholder’s Equity”.

In short, if the whole company will be sold, their priority will be to pay first their creditors, then what is left will be for the shareholders of the company. So if the Total Liabilities supersedes the Total Assets, that will be a dire situation for the shareholders because there will be almost nothing left for them.

The Price-to-Book Ratio

P/B Ratio is one of the popular relative valuations used, only next to P/E Ratio. This is computed by Dividing the Current Company Stock Price to its Book Value Share (BVS)

Book Value (BV) is also called Net Asset Value of the Firm, or equity. Why NET ASSET? because it is the value of the company’s Asset after subtracting all of its Liabilities. So that’s Book Value, then for us to to get the Book Value per Share (BVS) we now need to divide the Book Value of the company to its Total Shares Outstanding. Below is the formula and example of it ;

• Scenario: Elmads Corp (a sample made up company), have total Assets of £500 million, with Total Liabilities of £400 million for the Fiscal Year (FY) 2021. The company’s total shares outstanding is 10,000,000 (10 million) shares. What is Elmads Corp’s Book Value and Book Value per Share (BVS) for FY 2021?

Book Value (BV) = Total Assets – Total Liabilities

NOTE: You can find these information on the company’s most recent annual reports, or with various financial investing apps and websites in the internet.

BV = £500 million – £400 million

BV = £100 million

Afterwards, we get the Book Value per Share (BVS)

BVS = £100,000,000 FY 2021 Book Value (BV) / 10,000,000 shares outstanding

Book Value per Share (BVS) = £10

Note: The BV and BVS are not relative valuation methods, it is just a prerequisite to arrive into the Price-to-Book Ratio (PB Ratio) of a company.

BVS focuses on the net asset of the company related to its company shares outstanding. The Price-to-Book Ratio on the other hand, tells us how much are investors willing to pay today for every net asset of the company.

Then we now calculate for the P/B Ratio

For example, Elmads Corp. FY 2021 BVS is £10, while the current stock price of the company is £800 per share.

P/E Ratio = £10 per share stock price / £10 BVS

P/B Ratio = 1

Elmads Corp’s FY 2021 P/B Ratio is 1. Okay, now we have the ratio, what now then? what does it relay and mean to us investors?

Do you remember about what I’ve said regarding Book Value and the Book Value per Share of the company? that both of them reflects the company’s general health based on their equity? And that the P/B ratio shows if the stock is reasonably priced when compared to its balance sheet?

If yes, then you’ve understand that a Price-to-Book Ratio of 1 and below is best, because we’re basically paying for the stock price that is equal or below to the Net Asset Value of the company.

What is actually the reason why P/B Ratio of 1 or below is excellent? it is for the safety of our capital when the company becomes insolvent (a complete shutdown, requiring for them to pay all of their creditors and return the remaining money to their shareholders).

To make it clear; I’ll further stretch the scenario of my ELMads Corp example. Let’s say the company went under Chapter 7 Bankruptcy which is the complete insolvency of their business operations after a few months. They are then required to pay all of their debts to their creditors and bondholders. For the company to do this they will need cash, this means that they will sell all of their assets like their Property, Plant, Equipment, Remaining Inventory and other more, so that they can convert it into cash, which they will then use to pay their debts.

So, going back to their balance sheet; Elmads Corp (a sample made up company), have total Assets of £500 million, with Total Liabilities of £400 million for the Fiscal Year (FY) 2021.

Once they pay let’s say all of their liabilities worth £400 million, then the remaining Assets they will have is worth £100 million (Total Assets – Total Liabilities). So, basically if we bought it at a P/B Ratio of 1, then we’ll somehow expect that we will still be receiving our initial capital invested on Elmads Corp. But, if we bought it at P/B Ratio higher than 1, most likely we will not be receiving 100% of our initial invested capital in the company, the chances lower if we bought it way way higher than P/B Ratio of 1.

Below is the a simple chart showing the P/B Ratios and its corresponding capital safeness.

NOTE: This P/B Ratio Capital Safeness Percentage do not have anything to do with the percentage safeness in terms of the stock price volatility. What it only shows is the safeness of our invested capital if the company liquidates all of its assets due to insolvency. It is the projected percentage chance that the investors who invested in that specific company, who due to unfortunate circumstance will go into bankruptcy, will receive back their invested capital. Nevertheless, this is only a guide and a lot of factors can still influence the chance of the investors receiving back their capital in a company undergoing insolvency. This is not an accurate measurement and most importantly not with 100% with certainty.

Price-to-book per industry

Price to book ratio differs per industry. P/B Ratio for most technology companies are at sky high levels, you’ll be seeing them hovering at more than 5x Book Value, others are even at 10x Book Value. A lot of factors contribute to this but most technology companies are Asset light, meaning they do not need a lot of physical assets to generate a lot of income for the company. They can grow their income stream without needing a lot of fixed assets (physical assets), that’s the uniqueness of technology companies, this is also the reason why people find it hard to value companies in this industry.

The Tech industry grow their income through software which are not physical assets at all, unlike the utilities, oil & gas in which they need a lot of machinery, property, plant, equipment and employees in order to expand, and increase their income. Whereas, some tech companies will not be needing such massive amounts of Property, Plant & Equipment (PP&E) anymore due to the nature of the technologies they further improve through research and development. This is why with so much revenue generated and projected income growth, comes a faster rise in their stock prices, while the Book Value doesn’t need to significantly increase just to produce that massive future income. Henceforth, a very high Price-to-Book Ratio.

This is also the reason why P/B ratio’s popularity and usage has been declining for the past several decades.

That being said, Price-to-Book hasn’t completely gone out of its favour, as it can still be used for companies who have large quantities of fixed assets (such as lands, buildings and equipment) to operate their business. Furthermore, P/B Ratio is highly used metric for banks, because the assets of banks are mostly the money they have in their balance sheet. Money itself is how banks make more money, that itself is a significant part of their equity that is why P/B is a get go metric still being used when valuing a bank.

To sum it up

Just like the Price-to-Earnings ratio, Price-to-Book ratio is only a guide to support our investment thesis, it is not the sole metric that will dictate if a company is a good buy or not. It is one of the hundredths of metrics in making our investment research and thesis.

“Relative Valuation – The Price-to-Tangible Book Ratio will be posted Next Week 15-11-2021

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.