Price to Book: “An Illusion”

A financial ratio that is used to compare the market value of a stock to its book value is called price to book ratio or P/B ratio

Price to Book ratio = Share price / Book value per share

Book value is nothing but what the company own – i.e. assets – minus what the company owes – i.e. liabilities – is equal to book value of the company (it is nothing but the company’s total equity)

In another context, book value is what we will get at the liquidation of the company, and that will be its assets minus liabilities (Net assets)

Hence, book value per share = book value / outstanding shares

Here’s the calculation of the P/B ratio for asset-heavy companies from the cement and steel sector

Here, the book value of 1.43 & 1.45 interprets that for 1 Rs book value of equity share (or net assets), we have to pay 1.43 & 1.45 Rs respectively to buy the company’s share

Now let’s analyze P/B for IT sector companies

It is clearly visible that, both IT companies are available at a costly price in the market than earlier companies which were capital intensive, as per normal P/B ratio interpretation

But that is not true

Let’s see what exactly the Price to Book (P/B) ratio is.

Price to book ratio precisely shows that what we are paying for the companies Net asset/Book value/Total equity

Hence, from this statement, we can say that companies which’s revenue are being generated by their assets reported on the balance sheet, are only eligible for the application of P/B

Because, companies with lower assets, which’s assets are not their revenue-generating base, are not eligible for the application of P/B

Let’s understand it practically

In our 1st example, we find the P/B of Ambuja Cement and JSW Steel, which are asset-heavy businesses and which rely on their asset to generate revenue

Both of these are available in the market on lower P/B (which we have interpreted earlier)

In our 2nd example, there are TCS and Infosys, which are IT companies, which don’t have high assets, and their assets are not their revenue-generating base, but their employees are their true revenue generators

Hence, we get such high P/B like 10.15 for TCS and 6.14 for Infosys

Hence proved, P/B is worst when it is applied to service sectors, because they don’t have assets, but work on employees for revenue generation

Takeaways:

P/B ratio generally assumes that what if the company is on the verge of liquidation

We can’t apply the P/B ratio on every sector (as we show, it is worthless for the service sector); But it is good comparing and valuing measure for sectors like cement, steel, bank, manufacturing, etc. who have an asset on their balance sheet from which they bring their revenue

Service sectors generally don’t have hard assets, their employees create revenue for them, hence with no asset & lower Book value and high price, P/B is not applicable there

Companies who have depreciating assets, are also risky at measuring through P/B as their assets at book value get depreciated over time and if there is actual liquidation, the company may not get the book value of the asset also

The ratio is not useful for comparing firms in different industries and countries

When comparing two stocks with similar growth and profitability, P/B can be useful for determining which is available at the best price at that moment in time

P/B ratios can also be useful if a company has inconsistent or negative earnings since common metrics like price-to-earnings (P/E) wouldn’t be meaningful in these situations

Combination of P/B and ROE can work great if you are evaluating companies of same & eligible sector and same performance

Published by Aakash and Meet

I am Aakash Raotole I am currently doing Bcom from Dr. Patel and Rb Patel commerce college I am currently studying at finnacle investment academy Recently done distance internship with windrose capital, Pune - for a period of 14 weeks I am Meet Bhatt Completed HSC in commerce Now studying finbridge program at finnacle investment academy and Bcom externals I had completed CFA institute's investment foundation course and distance internship with Windrose capital, Pune - for a period of 14 weeks

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