Dear readers,

After the article about the most commonly used fundamental analysis indicator (Price/Earnings) which you will find here, it's time for the next one. Now, we will deal with the relationship between the share price and book value of the company called P/BV (Price/Book Value).

 

What is a book value?

To simplify, we can say that the book value is the sum of the company's assets, less its liabilities. What are the assets and what are liabilities you can see in the table below.

source: own elaboration

Imagine a situation in which the company closes its activities and exit the market. The company pays its liabilities and sells all assets. The amount of cash remaining after liquidation corresponds exactly to the company's book value. Each listed company is required to provide its book value in financial reports, usually on a quarterly basis.

The current price to book value can be read from financial statements or simply from various types of investment services. The following example of General Motors comes from finance.yahoo.com website.

source: finance.yahoo.com

Price to Book Value is denoted as Price/Book, this is really common abbreviation of this indicator.

It is worth to emphasize that the book value of the company may increase rapidly, for example, during mergers or acquisitions. It decreases on the basis of various types of write-offs, redemptions or dividend payments. Because the book value is constantly changing, we should refer to the most current data.

 

What does the P/BV indicator say?

P/BV indicator informs us how much we pay for 1 USD of actual company assets (assets less liabilities). This is the current share price of the company divided by the book value per share. We can illustrate this with the formula:

Since the  P/BV ratio tells us how much we pay for 1 USD of the company's equity, we can expect that if we buy shares at the rate equal to or lower than the book value per share (P/BV less than 1), they are undervalued. In fact, it is a bit more complicated. Although you can actually say that the lower the P/BV ratio the better.

Let's use the example of the aforementioned General Motors:

1. General Motor shares cost 40.10 USD

2. Book value per one share is 52.53 USD

3. We divide the value from point 1 by the value of point 2 and we get the result P/BV = 1.31.

The most common interpretation of the indicator is that values below 1 mean undervaluation, and above 3 mean overvaluation.

Particularly noteworthy are shares with a P/B ratio below 1. Even if the company went bankrupt the day after the purchase of its shares, we get theoretically profit from its investment. This is because the company's equity is worth more than the amount invested in it. It's a bit like a bargain.

However, this is quite a simplification.

In fact, the size of the indicator considered as good varies depending on the sector in which the company operates. Mining or production companies need a lot of fixed assets to generate revenue: factories, warehouses, production machines, etc. On the other hand, Facebook-style technology companies generate huge revenues mainly using intellectual goods, not included in the company's book value. Therefore, we should adopt different evaluation criteria depending on the type of company we analyze.

  • For commodity companies P/B should be in the range of 0.4 - 2.0,
  • Values ​​between 5 and 20 are typical for technology companies.

Despite such a wide scale, too high value of the indicator is obviously unfavorable and informs about absurd valuation of the company. A great example is Tesla, which despite the use of advanced technologies is still a production company with a P/BV ratio above 7. Mastercard, being a technology company, has a price to book value above 50. On the other side, there is Gazprom, which, even after recent 60% share prices increases, has P/BV of 0.37. This means that when we buy Gazprom shares, we pay only 37 cents for every dollar of the company's book value.

 

Is P / BV effective?

Strength of the P/BV indicator lies in its simplicity. Using it, it's easy to see how the stock price relates to the real value of a company. High levels of this indicator may indicate a significant overvaluation of shares. In turn, P/BV below 1 indicates a strong undervaluation, i.e., an attractive share price - at least in the long term. Studies confirm this. In the long run, assets with low P/BV (cheap) are a better investment than securities with high ratio (expensive).

Graphic below, extracted from report published by starcapital.de shows strong relationship between the P/BV ratio and average returns on investments over the next 10 years. The study covered 1979-2015 period.

source: starcapital.de

We see that investment in markets with P/BV lower than 1 was a guarantee of excellent (two-digit) average annual returns. An indicator above 3, in turn, brought almost no returns or even losses. This correlation is even more evident when we use the graph.

source: starcapital.de

On the example of 3 countries: Japan (red), Sweden (yellow) and Denmark (green) and the global MSCI index (blue), we can see that the high P/BV value presented on the horizontal axis is usually associated with a poor return on investment in subsequent years (vertical axis) and vice versa.

This type of research proves that it is worth using the P/BV ratio not only when valuing companies, but also for entire markets. Currently, the disproportion between markets in terms of price to book value is really big.

source: own elaboration

The above list illustrates a significant regularity. Currently, emerging markets are cheap. India and Indonesia are exceptions. Many developed markets have a P/BV ratio above 2, and the U.S. stock exchange representing almost 50% of global capitalization above 3. As we have presented earlier, in the following years, countries such as Russia and Turkey should bring profit to investors. Developed markets with the U.S. as a leader are rather doomed to poor results.

A certain justification for developed markets, especially for the U.S., may be the fact that in their case the majority of market capitalization are technology companies, and those as we know have naturally high P/BV. Therefore, in the table, next to this ratio, we have also placed other indicators, including CAPE and P/E, P/S (Price/Sales) and DY (Dividend Yield) we have already learned. If we consider them all, then we will notice that the overvaluation of developed markets is not accidental.

 

P/BV as part of the F-Score strategy

F-score was developed by Joseph Piotrosky of Stanford University. It has been used since 2000, but it was widely heard of after the Lehman Brothers bankruptcy. After the Great Financial Crisis, the American Association of Individual Investors published rates of return generated by 56 different investment strategies. It turned out that only the strategy based on the P/B ratio and F-Score ranking brought profit in 2008 and it was as much as 32.6% while the median for other strategies was -41.7%.

It is worth mentioning that one of the basic elements  of the F-score strategy is selection of companies in terms of the price-book value ratio. Only 20% of companies with the lowest P/BV are considered for further analysis in this strategy.

 

Limitations of the P/BV indicator

The price to book value ratio can be misleading in two cases:

1. Book value is overstated, and thus a company has an attractive low P/BV ratio.

It is very difficult to demonstrate lower than the actual value of liabilities. Debt is debt and if it is not repaid it can only grow. Therefore, the overstated book value results come from the outdated or incorrect valuation of the company's assets. For example, imagine that the company we are analyzing produces miners for cryptocurrency production. It estimates the value of the outstanding goods in the warehouse at 50 million USD, which is 50% of the value of assets. Meanwhile, it turns out that over the last quarter, the technology of the processors used in this type of equipment has changed. Previous excavators have become obsolete. The company can now sell them for only a fraction of their previous price. In this case, almost half of the company's assets have evaporated, although they still exist on paper. If we add to this debt increase, it may turn out that our latest data on the company's P/BV ratio are very outdated.

In the case of overstating the book value, the basic rule applies, the more complex the product that the company offers, the more difficult it is to price it. This applies especially to goods and services from new technologies sector, patents and items affected by fashion and trends.

2. Real book value is understated.

For the investor, this is good information, it means that the P/BV ratio is higher than it should be. This situation applies to companies with natural resources, i.e., energy, industrial or agricultural commodities, but also land. Valuation of a given commodity may be updated too seldom (this is often the case with land). Consequently, goods owned by the company have in reality much higher value than that shown in the accounting books.

In addition to the two cases described above, it is worth remembering that low P/BV ratio may also mean that the company is "overinvested". This means that maybe during good times, it has invested a lot of capital in assets that are currently not fully used and do not bring expected profit. Another example is a venture capital investment company that has invested a huge amount of money in a startup, which very quickly turned out to be a complete failure.

 

Graham's P/BV

The father of fundamental analysis Benjamin Graham and author of the book "Intelligent Investor", which we strongly recommend, also noted that the P/BV ratio has some disadvantages. He proposed a modified version of this indicator called today Graham's P/BV, which is shown in the following formula:

As we can see, Graham's indicator is similar to the classic one. The difference is that it eliminates non-current assets that are part of the company's capital, focusing on current assets. Generally, in this way we promote companies with high liquid assets and low debt. Book value calculated according to Graham is easier to cash out, thus companies with low P/BV Graham maintain better liquidity and are somewhat immune to bankruptcy. The use of this type of indicator also makes sense for commodity companies whose main problem is to get rid of fixed assets. After all, mining equipment or communication infrastructure used in the operation of a specific place is hard to sell or transport later.

Graham's indicator is always higher than the classic P/BV, but also often takes negative values. It is companies with a lot of fixed assets in relation to current assets that are usually characterized by a negative value of this indicator.

Graham's P/BV eliminates the outdated valuation of fixed assets, but can also be misleading. Current assets may, after all, be inventories that cannot be sold or receivables that cannot be recovered. Nevertheless, this indicator next to the F-score may be a better solution if we are looking for companies with a low risk of bankruptcy in the event of a possible crash.

 

Summary

1. The price to book value is a good measure of real value of both companies and entire markets. Unfortunately, to achieve returns based on this indicator it is often necessary to wait months or even years.

2. Attractive levels of P/BV vary depending on sector in which a company operates. Commodity companies generally have low level of this indicator, and technology high.

3. Currently, low P/BV mainly concerns developing markets. Developed markets are overvalued.

4. P/BV is part of the Piotrosky's Strategy - the only respondent who brought profits during the 2008 crash.

5. In some cases, behind low P/BV can be unreliable or outdated valuation of a company's capital.

6. We should definitely not make our investment decisions solely on the basis of P/BV, but always use other fundamental analysis indicators at the same time.

 

Independent Trader Team