Price/Book Value is a ratio that compares stock price per share with book value per share.
This ratio indicates the price an investor is willing to pay in order to have one Euro of Book Value.
EXAMPLE
Simone Ltd has 425 million Euro in assets and 325 million in liabilities on the balance sheet; book value of the company is 100 million.
If 50 million shares are outstanding, each share represents 2 Euro of book value.
If each share is traded on the market at 30 Euro, P/BV ratio is 15 (30/2).
In this example, an investor pays 15 Euro to have 1 Euro of Book Value.
Investors are willing to pay a high price because they believe the company will grow in the future and increase its value.
P/BV is useful in identifying stocks undervalued or overvalued!
However, it is also true that investors receive 1 Euro if the company is liquidated today………
P/BV is also useful to test the safety of the investment!
Price/Book Value is considered an easy-to-use tool to evaluate the quotation of the company’s share. However, this metric is subject to manager manipulation because the denominator is an accounting figure. For example, the management can ask for a loan to the bank in order to collect cash to buy back their shares. This operation will increase the stock price in the financial market and reduce the value of the shareholders’ equity with a positive effect on the P/BV ratio.
P/BV >1
When the ratio is above one means that investors are willing to pay more than the worth of their net assets. In this situation, investors believe in the future growth rate of the company, and they are willing to pay a premium for this possibility.
However, the bigger the ratio the riskier is the investment because investors pay a high price for the stock, but they will receive just 1 Euro if the company is liquidated today.
P/BV <1
When the ratio is less than one, investors do not believe in the future prospect of the company, and they trade the stock into the market below the worth of the company’s net assets. In theory (more difficult in practice…..), an investor could buy all the outstanding shares of the company, liquidate the assets and earn a profit because the assets are worth more than the cumulative stock price.
When the ratio is less than one, it is possible that the market test correctly companies with real difficulties and fundamentals that justify the quotations. However, it is also possible that the market is bearish, and the negative sentiment brings down also firms with solid fundamentals. Value investors usually analyse companies in order to identify these opportunities: to buy at a price below their intrinsic values and sell in the future when the quotations will reflect their real value.
Price/Book Value vs. ROE
Price/Book Value is often looked in conjunction with Return on Equity (ROE).
Investors are usually willing to pay higher multiples of book value for stocks that should guarantee a high return; companies with high ROE typically have high P/Book Value.
Companies that do not guarantee a high return rarely have a high P/BV.
Significant discrepancies between Price/Book Value and ROE are often a signal of an undervalued or overvalued stock.
When a stock presents a high P/BV and a low ROE, the stock can be overvalued.
When a stock presents a low P/BV and a high ROE, the stock can be undervalued.
Price/Book Value depends on the sector
Because of the characteristics of its denominator, P/BV depends on the industry the company operates.
IT companies, which main assets are intangible, can trade at a P/BV of 10 or more. The reason is the conservative approach of the accounting figures that are not usually able to capture the real value of the intangible assets. P/Book Value is not normally used to evaluate this type of companies.
Consultancy companies, whose principle assets are human capital, usually have high P/BV. The reason is the conservative approach of the accounting figures that are not able to capture all factors that drive a company’s value, such as a unique workforce skillset. P/BV is not usually used to test these companies.
Telecommunication companies and other highly leveraged companies usually present a high P/BV, because they finance their assets with debits that represent the major portion in the liability section in the balance sheet.
Manufactories companies’ present high level of tangible assets on their balance sheet. P/Book Value is considered a valuable tool to evaluate these companies.
Banks hold relatively liquid assets on their balance sheets that are usually traded at their fair market value; bank’s balance sheet should be equal to the fair market value of its assets, and for this reason, Price/Book Value of these companies are usually close to 1.