11:10 PM, 23 Mar 2017 (AUS EDT)   The market is currently closed       

Fundamental Analysis: Qualitative Factors, Book and Price to Book Ratio

If the human body were broken down into its key minerals and sold, we would be worth roughly 3 to 5 dollars on average. If a car is torn apart and sold piecemeal it would cost multiple times more than as a package. The question is: what is that publicly traded company worth? A value investor will be deeply interested in how to dissect a company and try to add the sum of the parts.

Book Value per Share is Fundamental Net Worth

Pricing a company's worth is a very difficult calculation that still cannot be achieved through numbers alone. Worth is relative. What is concrete is actual hard asset value. Book value provides the net value of the company by adding all the assets together and subtracting the liabilities.

Book value requires that the company add up its worth: buildings, vehicles, computers, desks, fuel, calculators, and so forth. Next it subtracts the debt and liabilities. The resulting number divided by the amount of shares will tell you how much hard value per share the company has.

  • A retail company of a net worth of 100 million dollars that has 10 million publicly traded shares has a book value of 10 dollars per share.
  • A video game company with a net worth of 10 million dollars with 20 million shares has a book value of 50 cents per share.

Of course, this doesn't tell you much unless you know what the share price is. One might assume the first example is a better stock to pick. But if the first example was trading at 100 dollars per share and the bottom example at 10 cents per share the valuations would be different. For this reason we need Price to Book ratio.

Price to Book Ratios Provide Valuation

Simply divide share price by the book value to arrive at "price to book" value. What does this tell you?

  • A low price to book value is seen as a value play

Low book value also provides some assurances to the investor. Even if the company were to file for bankruptcy and disperse the remaining amount of capital amongst shareholders, we can still calculate our total risk or loss. If the price to book value is very low we might not lose any money what so ever making this a safe play.

Keep in mind that companies that have few assets such as Internet based companies will have skewed price to book ratios that make it hard to access. Price to book ratios are best used with a more traditional company that has equipment.

But are all stocks that have price to book ratios close or under the number "one" an immediate value pick that we should jump on?

Be Wary of Low Price to Book Ratios

If the price to book ratio is under one, it could be:

  • The bear market is unfairly punishing all stocks regardless of worth
  • Investors have not noticed the low book value and it's a great value pick
  • Investors are calculating value differently than "price to book value"

The first two reasons could make for a good long term stock pick. However, there is also the chance that investors see something in this stock that the "price to book value" fails to highlight. What?

  • Asset and debts calculations vary

There are numerous ways to calculate assets and debt. How has the company calculated asset value depreciation over time? Is there an allowable percentage stipulated in some rule book or is the depreciated value closely tied into market value? Either scenario can be risky as an allowable amount might be too little to reflect true deprecation thus leading to an inflated book value. Or market value of the assets might be high because of a bull market. If the company goes bankrupt and needs to sell all of its assets, the sale during tough economic times could be below expectations.

But the reverse can also be true. Perhaps the assets have been depreciated more than what the market will currently purchase them at. This could mean that the book value is actually much higher in true value than the ratio suggests.

One other caveat to watch for: liens against the loans. Often when a company goes bankrupt they need only pay a low percentage back on liabilities. But if credit was tight and they needed to put up assets as collateral, this will need to be factored into book value if the liens were not insured against bankruptcy. Instead of paying the reduced bankruptcy percentage, the company might be obligated to pay the full amount back on certain loans. Just make sure to read the fine print.

How to Pick Good Price to Book Ratio Stocks

Although the analysts have been saying for years that computer screening has removed the ability to find good "price to book" value plays, some traders seem to keep finding the diamonds in the rough. How? What is their secret?

  • Large companies with big assets
  • Stocks without high growth and not in the limelight

The scenario might play out this way…

The firm is very large and has a large amount of real estate. Also, the company could have a large amount of commodity assets that will appreciate with inflation. The company's industry group is not currently in the limelight or not very attractive. It could be a dirty business without high growth potential as to revenue or earnings. However, if the price to book value is quite low, perhaps under one this could be a very good value play with a decent upside once the market improves taking housing prices with it. If the company had a lot of machinery that would quickly breakdown and devalue, these assets would not be quite as lucrative.

Bottom Line with Price to Book Ratios

The "price to book" ratio is far from being the final word in the matter of quantitative fundamental analysis. However, it is a good place to start for those that want to try determining absolute valuation on a stock. A relative value such as a P/E ratio might be low compared to its peers, but may still be extremely high when compared to actual assets the company owns.

Just be forewarned that the way a company depreciates its assets, if it pays dividends, and any liens against the loans will change the way we view the fundamental analysis technique of interpreting "price to book" ratios.