Brokers and equity analysts will use a wide variety of financial tools to determine the true worth of a share. One such analysis tool which can easily be found in Integrated Investor is the Price to Book ratio which has a variety of potential uses when it comes to clarifying the value of a stock.
Price to Book (P/B) value is easy to calculate being the ratio of a company’s share price over its book value of equity. The share price is reported every minute of every trading day by the exchange, so that is something very familiar to us however the book value of equity might be something more foreign.
First, we need to look at the book value. This can be found on the balance sheet part of the financial reports and is “the total value of tangible assets minus total liabilities”. Tangible assets are those which can be easily quantified (or physically touched), such as machinery, land and raw materials. It doesn’t include the value or worth of brands or intellectual resources (which are intangible assets) which are a little harder to directly quantify. In other words, the book value is how much ‘actual stuff’ the company has, less how much the company ‘owes’.
If we imagine a firm has $50 million in tangible assets and $40 million in liabilities, then the book value is $10 million. The book value of equity involves looking at this number in relation to the total number of shares on issue. If we go on to assume our fictional company has 5 million shares outstanding, each share would represent $2 of book value.
If we then find the stock price we can calculate the P/B ratio. Let’s say the stock price is $5, then the P/B ratio is simply:
P/B = $5/$2
P/B = 2.5
If we delve down into the components of the ratio, we can instantly get a rough idea of what the market is willing to pay for a company, above and beyond its ‘hard’ assets, effectively comparing the financial accounts of a company and the market’s valuation. The higher the P/B ratio, the higher the premium the market is willing to pay for a company above its hard assets. A low ratio therefore may signal a good investment opportunity.
In the example of XOM:NYSE below, we can interpret the charts to reveal that the P/B ratio has been decreasing for several years. The market is putting decreasing emphasis on XOM’s worth above and beyond that which is shown on the balance sheet. The excess excitement associated with energy price increases in a global growth cycle has diminished and XOM investors now value the company closer to the physical assets it actually owns, rather than hype. XOM is closer now to fair value than it has been in the last 5 years.
If the P/B ratio was going to be our only point of reference before deciding whether or not to buy or sell an investment, it may be possible to go on to suggest that XOM is undervalued by the market as of the end of the last financial year. Regardless of this perspective, all good investors and traders will look for confirmation or corroboration from other indicators or their charts. For an investor a ‘buy on dips’ strategy could be employed, whereas a trader may look now for an Elliott Wave 4 strategy.
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As with all indicators, the P/B is not without its limitations. It was noted earlier in the piece that the P/B only considers the tangible assets of a company. Some companies, such as software designers, have a large degree of their value in assets hidden from the financial statements. Knowledge collected from trial and error in software design or marketing may be a huge benefit to a firm’s bottom line, but is never really represented anywhere on the balance sheet. On Coca-Cola’s balance sheet, for example, there will be no facility for the accountants to represent the worth of their well known red design, but 90% of the world’s population can instantly recognize it when they get have a thirst. What’s that really worth?