Price to book value (or price to book ratio) is a way to value a company based on its property. We can use this to work out if particular shares and ETFs are cheap. Here’s how to read the price to book value/ratio like a boss and spot opportunities.
I wrote this to accompany the post on P/E ratios. You should read that one first, then this one.
What is price to book value / price to book ratio?
Price to book value is a multiplier that says how many times more it would cost to buy all of a company’s shares compared to buying the stuff that the company owns yourself. So, if a company has a price to book ratio of 4, the share price means that buying all shares to own the company would cost four times as much as buying the company’s assets. On the other hand, a price to book value of less than 1 means that it’s cheaper to buy into the company than it is to buy the stuff it owns – basically, this means that all of the employment contract, workers and so on aren’t currently included in the share’s price.
Why does price to book value matter?
A company isn’t just a big pile of physical stuff and some intellectual property: it is a function of using that stuff to make money. This will need a real world example to explain it.
If companies were just physical stuff
Let’s say that you decided to set up a company making furniture. You buy a factory, some machinery, some designs for furniture and so on. That’s your stuff – the things that are in this “book” which price to book value is talking about.
This doesn’t make money, not on its own. You need employees to work the machines, marketing and sales teams to sell your finished products, and you want a good brand reputation so that you can sell the products at a high mark-up and make lots of profit.
The value of a company is the result of all of this stuff, people and functions coming together to create things. If it was just book value, you’d be saying that the company was only worth what it had: you may as well send everyone home as their work isn’t helping to make any money. Most of the time, that’s clearly daft.
What this means is that price to book value shows what affect the people, philosophy and processes of a company are having on market price. This can be either a good or a bad thing.
What is a good price to book value?
Investopedia claims that a good price to book value is less than 3, but ideally less than one. Benjamin Graham’s book The Intelligent Investor advocates for keeping it as low as possible. The idea is that if a price to book value is lower than one, there’s little risk (according to Graham) in buying the company, since it is basically cheaper to buy that company than its components. Presumably, this is because you’re getting the people, expertise and reputation bundled in for free.
Can you really buy shares in the UK / US with a price to book value of less than 1?!
I had a scout around the investing.com’s share screener tool for market data, looking for shares with this dream price-to-book value of less than one. I found 641 results, which was a pleasant surprise!
There were some big names in there. Given the pandemic at the time of writing, the shipping firm Maersk, the car manufacturer Volkswagen and the oil refiner Royal Dutch Shell didn’t surprise me. However, HSBC did, as did Vodafone (who were later on the list). I decided to follow this up a bit further.
HSBC
OK, HSBC has a price to book value of less than 1. On this alone, so far it looks like a good value stock!
However, the P/E ratio is higher than Benjamin Graham’s magic 25. On this basis, HSBC could be good value, but just as easily could not be. What we can say for sure though is that HSBC is undervalued compared to its competitors.
Vodafone
If anyone is a value purchase, surely it’s not the behemoth of British telecoms, Vodafone? Let’s have a look!
Well, from a price to book and a P/E ratio perspective, Vodafone certainly looks like a good value buy. The P/E is under Graham’s magic 25, the price to book value is less than 1. Surely that’s all good and I should throw my money into it without a second’s thought?
Actually, no. Here’s where we talk about how price to book value has weaknesses.
Why price to book value isn’t the best
Some industries don’t work with material “stuff”. For example, a tech company might have a small amount of intellectual property, like software, that it just uses effectively and makes lots of money from that. Sure, its laptops, computers and office space will be included in the book value, but the market might be just waking up to the company and it might be generating lots of high-paying orders really quickly. It will probably have a high price-to-book ratio already, but still be a good investment because it’s expecting to grow rapidly as it dominates its space.
Vodafone looked like a cheap buy a moment ago, but when we look at the balance sheet there’s a few red flags for me. Firstly, the “cash and short term investments” figure is smaller than the “total current liabilities” figure. This means that the company either needs to borrow some money, sell some money-generating assets or have a magically good sales year to pay down those bills.
The second point that concerns me is that “goodwill” is valued so highly. It’s actually valued at more than the cash and short-term investments in the bank. I mean, it’s not far below the total current assets of Vodafone.
Goodwill is just a figure given to account for things like brand recognition, reputation, employee relations and so on. These are things that help a company sell products or services, so it makes sense that they have a value of some kind. However, it’s not clear what that value really is until you sell a whole company. This means that it’s easy to abuse.
Fortunately, there’s another ratio that accounts for this.
Price to tangible book ratio
Price to tangible book is like price to book value, except that it’s only for tangible items: products, inventory, equipment and so on. Things like intellectual property or that shady “goodwill” figure get excluded.
If you have another look at Vodafone’s balance sheet, “goodwill” has jumped up in 2020. There might be a reason for that, but we’d have to look at the director’s report in the annual accounts on Companies’ House to check. (It’s beyond the scope of this article but you’re free to have a look!)
However, going back to the valuations, we can see that Vodafone had a price to tangible book value of a little over 7. That means that when you buy a share in Vodafone, a little under 1/7th is actually stuff that you’re buying. The rest is patents, ideas (intellectual property), brand recognition, reputation and so on. That’s actually not ridiculous for a company that sells mobile phone bandwidth, but it’s something to be aware of. If the company goes bust, shareholders are entitled to a proportion of the company’s assets. What are you going to do with a millionth of a dead company’s reputation?!
Price to tangible book ratio is a problem for companies that are heavy on IP or skills. IT companies, for example, would expect to have a terrible price to tangible book value. However, that doesn’t mean that it isn’t useful to look at if you suspect that a price to book value has been manipulated and you want to see what you’re physically buying with your money.
How I use price to book value
I don’t buy many loose shares. I do have a couple that I believe in and I generally buy them if they have a price to book value of lower than 4.
What I usually buy are ETFs. Interestingly, these also have a value (the things on the book are the actual shares that the fund owns). You can see an example from a Vanguard index fund that I don’t own and have no intention of owning. No, Vanguard aren’t paying me, they just have an easy-to-read site.
For ETFs, this is an average (mean) price to book value of all of the shares than the fund buys. Yup, that’s about it. We can see here that it’s pretty low in Europe excluding the UK, which suggests that European companies own quite a lot of physical assets.
In the opposite end, the S&P 500 seems to have a much higher ratio. That could be because the S&P 500 is super popular and currently overpriced as a result (looking at the P/E ratio, that’s quite likely) or it could simply be because there’s more tech companies on the S&P 500, who mostly run on ideas and execution of them.
I recently stopped paying into a video games ETF, based on P/E and price to book. I’m still a believer in investing in games, but the P/E hit 45 and the price to book value was way above 4, so I sold it. I don’t want to be left holding the bag when the price tanks!
Conclusion
Price to book value is a way of measuring what asset you’d own with your shares if a company goes bust. It’s pretty good for companies that are asset heavy, like manufacturers or real estate companies, but it’s less useful for companies that are tech-heavy. As we saw with Vodafone, the price to book value can be manipulated with “goodwill” values. It’s also not the whole story, and there are several reasons why it could be misleading. Still, if you combine it with P/E ratio it’s a pretty good indicator of shares and indices which are potentially undervalued and have some growth in price expected when the market realises what it’s sat on. We also saw that funds will show average price to book values across their holdings.
