There are millions of companies in the world. And they all do different things. But as an investor, you can break each and every one of them up into three basic components.
Let’s take a very simple example. Say a friend approached you, and asked you to invest in his carpet shop. What would you look at?
For one thing, you’d want to make sure he was selling his carpets at a profit. He’d need to be selling them for more than it cost to buy them from the manufacturer. He’d also need to be making enough to cover his costs, like heating and lighting the shop, or paying any staff.
Another thing you’d consider is cash flow. Does he sell his carpets on credit? That might enable him to sell more carpets. But if he has to pay his suppliers before he gets the money from his customers, he could easily run into trouble. Many apparently otherwise sound businesses go to the wall because they run out of hard cash. We’ll discuss this more next time.
Finally, you’d look at the value of the assets themselves. If the company did go to the wall, how much could the component parts be sold for? What’s the shop worth? What about the value of any carpets sitting in the stock room?
Handily enough, each of these crucial components – profitability, cash flow, and assets – are reflected in three key financial statements in every company report.
There’s the profit and loss account; the cash flow statement; and the balance sheet. Each has its uses. But depending on the company, one might be more useful than the others.
How do you value asset-intensive firms?
We’ve already looked at the price to earnings (p/e) ratio and the price/earnings to growth (PEG) ratio in this series. One weakness of each is that they focus exclusively on a firm’s earnings, taken from the profit and loss account. That can be a problem.
Why? Because for some types of company, the key measure of whether or not they are attractive investments, is not their earnings.
That might sound odd. But just think about property companies, or investment trusts (firms that buy shares in other firms on behalf of their investors).
While earnings are important, these firms are judged as much, if not more, on their ability to generate asset growth, or boost the long-term size of their investment ‘book’.
For example, rental income is important to a property company, but investors will also want to see the capital value of the underlying property portfolio rising.
So to properly value such companies, you need a different tool from the p/e. This is where the price-to-book ratio (p/b) fits in.
But what exactly is the ‘book’?
We’ll look at how to calculate p/b in a moment. But first, just what is the ‘book’?
This is the firm’s net asset value, according to its balance sheet. What does that mean? Well, a balance sheet is a snapshot of exactly what a firm is worth, according to generally accepted accounting rules.
To get the ‘net’ asset, or ‘book’ value, you add up a firm’s liabilities (what it owes – perhaps to third parties such as trade suppliers, or to the tax office). You then add up the value of its long and short-term assets (so things like buildings, stock for resale, cash and so on).
Take the liabilities away from the assets, and you’ve got your book value, or net asset value.
Once you’ve got that, it’s a simple matter to calculate the p/b. You just divide the current share price by the book value per share.
Say the firm has a ‘book value’ of £100m. It’s also – conveniently enough – issued 100 million shares. So the book value per share is £1 (£100m/100m). If the current share price is £1.25 then the p/b is £1.25/£1, or 1.25 times.
So what does that tell you?
In short, the lower the number, the better. If you are looking for a bargain, you ideally want it to be less than one. A ratio of 1.25, as in the example above, suggests you are paying £1.25 for assets that are currently only worth £1. That’s not much of a bargain, at least on the face of it.
You’d be much more interested if the result had come out at 0.8. Because then you’d be paying just 80p for assets with a value of £1.
If this interpretation all seems a bit too simple, that’s because it is. In reality – as with any ratio used in isolation – there are traps to watch out for.
The trouble with p/b
One general problem with this ratio is that it is based on the balance sheet. And balance sheets are only a snapshot of the company on a given date. So the figures may well have changed, sometimes quite dramatically.
This means the p/b compares apples with oranges to an extent – the current share price, which is right up to date, with the balance sheet, where the information is slightly older.
But the main problem is that the ratio’s accuracy relies heavily on the ‘book’ value for the firm being meaningful – ie, not too far from a realistic market valuation for the firm. That’s why it works best in asset-intensive sectors, where it’s easier to agree on a concrete value for an asset, and not so well in service-driven sectors.
For example, it starts to fall down when you look at a firm such as Apple. Apple’s p/b ratio comes in at more than six. Yet plenty of investors would still think about buying it even though on a p/b basis it’s a total rip-off. What’s going on?
The trouble with using p/b to value Apple is that there are certain key assets missing from the balance sheet. The value of the firm’s brand is the biggest. Since accountants only like to include things in a balance sheet that can be reliably measured, intangible assets such as reputation, staff quality and market share get left out, even although any buyer would clearly factor them in to a valuation of the firm. This can leave the ‘book’ a bit light and lead to artificially high p/b ratios.
How to use it
The p/b is a useful addition to your investing toolbox. And in certain sectors it should be considered one of the first ratios you’d expect to turn to in your quest for value.
However, like other ratios, it has some weaknesses and can be downright misleading in asset-light sectors. So once again, never use it in isolation, and make sure you’re using it on an appropriate company.
• This article is taken from our beginner’s guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here