In the previous article, we discussed how the P/E ratio is widely used by investors to determine how much the market is willing to pay on each dollar of the company’s earnings. However, the P/E ratio alone is inadequate for an investor to make an investment decision. In today’s article, we’d like to introduce to you the Price-to-Book (P/B) ratio. Before we analyse the uses of the P/B ratio, let us understand what is constitutes the book value.
What is the book value (NAV)?
The book value, often known as Net Asset Value (NAV), refers to the company’s net assets. The NAV is calculated by taking the company’s total assets less its intangible assets and total liabilities. Intangible assets (i.e. goodwill, intellectual property) are not included in the calculation of NAV because their values are usually overstated on the balance sheet. In other words, the NAV tells us how much the company is worth if it ceased operations, sold all its tangible assets and paid off all its debt obligations. However, if the company has to cease operations due to financial distress, the company may be liquidated for less than its NAV, depending on how quickly the company needs to liquidate its tangible assets to meet the debt obligations.
It is an accounting practice to record the value of its assets at historical cost. Hence, it is important to note that the book value and mark-to- market value of a company’s net assets may differ.
There will be an article written later on to explain the differences between book value, mark-to-market value, liquidation value, salvage value.
Why should I use the P/B Ratio:
Buying stocks with a low P/B ratio is considered to be one of the core tenets in value investing. In fact, this is only 1 of the 10 rules in Benjamin Graham’s (Buffett’s mentor) classic book on value investing, Security Analysis, Graham kept the rule simple by only considering companies with a P/B ratio that’s less than 1.5. Of course, shortlisted companies also have to meet other criteria mentioned in his book.
Although we’ve established in earlier parts that the NAV is not indicative of the asset’s current market value, I personally use the P/B ratio in all of my investments in Real Estate Investment Trusts (REITs). Unlike other types of businesses, REITs have a portfolio of properties which usually hold its value well over time. The market may temporarily price the value of a REIT below its NAV, making the P/B low. This presents investors with an opportunity to acquire the REIT’s net assets for less than its historical cost, with the prospect of capital appreciation.
The P/B ratio could also be of great significance when investing in a property developer. Stay tuned for CapitalistLAD Guide to Ratios: P/B Ratio (Part 2) next Monday where we look at an actual case study to better understand the application of the P/B ratio.
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Till next week, have a good weekend!