All companies acquire or develop a certain level of assets. Some companies may hold real estate and/or own the buildings and factories in which they operate.
Others may hold inventories of products or equipment, and others still may own other subsidiary companies. One question that value oriented traders seek to answer is “how highly does the market value those assets?”
Components of Price to Book Ratio (P/BV)
“Book value” is defined as the net asset value of a company, and is calculated by adding up total assets and subtracting liabilities. Book value per share is arrived at by dividing book value by the number of stock shares outstanding. This can be thought of as the amount that shareholders would theoretically receive per share of stock held if the company went out of business and all the assets were liquidated.
The “Price/Book Value” Ratio (P/BV) is calculated by dividing the price of a share of stock by the book value per share. So if a company has $100 million dollars in net assets and 10 million shares outstanding, then the book value for that company is $10 a shares ($100 million in assets / 10 million shares). If the price of the stock stands at $20 a share then the price to book value ratio is 2.0 ($20 price divided by $10 book value). If the stock price subsequently rises to $30 a share, then the P/BV would be 3.0.
What traders look for
Some stocks have a tendency to trade at a relatively low P/BV level. Others have a history of trading at much higher P/BV levels. As a result, it is not always possible to look at a given company’s current P/BV and deem it “high” or “low.” Therefore, it is typically best to compare a company’s current P/BV to its own historical range in order to get some historical perspective.
Similarly, the stocks in some industry groups such as manufacturing, typically trade at relatively low P/BV ratios. This may be due in part to the fact that manufacturing companies tend to own a lot of hard assets such as equipment and buildings. Equipment and machinery will typically not grow in value over time and may in fact depreciate in value. Buildings may grow in value but will tend to do so slowly over time.
The stocks of some other industry groups such as technology stocks typically trade at relatively high P/BV ratios. This may be due in part to the perception that a breakthrough technology might allow tech company to expand its earnings very quickly.
So it can also be helpful to compare a given company’s current P/BV to that of the average P/BV for stocks in the same industry group. All of that being said, some traders who focus on value factors to select stocks will start their search by focusing on stocks presently trading below book value, i.e., at stocks with a P/BV below 1.00. The underlying theory is to start by looking for stocks that allow you to buy $1 worth of assets for less than $1.
What traders look out for
Sometimes companies suffer serious misfortunes. Whether their product becomes obsolete, or they lose a lot of money on a company they have acquired, or a competitor launches a new product that takes a large portion of their market share, a company’s business can go south quickly and dramatically. Generally, the company’s stock will often follow as traders try to assess the true value. When this happens a stock can suddenly appear to be very cheap based on its sharply lower P/BV. However, if there is a significant change to the underlying business model the stock may not be as undervalued as suggested by the P/BV. This situation is often referred to as a “value trap”, where a company appears to be undervalued but is reality investors have simply not yet recognized the underlying negative change in the company’s fundamentals.
Likewise, because stock prices can move to extremes, it is possible for a stock to fall to an extremely undervalued level and then stay there for an extended period of time.
On the other end of the spectrum, when the P/BV for a stock reaches a significantly higher level than the stock has experienced in the past it may signal over-exuberance on the part of traders. This can often serve as a warning sign that the stock is overvalued. Still, remember that just because a stock sports a higher than normal P/BV, this does not necessarily mean that it won’t continue to advance nor that a sharp price decline is imminent. A stock with a high P/BV may imply that investors anticipate strong earnings growth as compared to the rest of the industry.
In order to use the P/BV ratio to assess how overvalued or undervalued a stock may be, you must compare the current P/BV with something else. These can include historical P/BV of the company or P/BV ratios of peers in the industry. If the current value is at an extreme high or low of the historical range for that stock you may be able to designate a stock as being over or undervalued.