Like the P/E ratio, I also struggle with Price/Book. However, I believe that P/B is a bit more complicated.
Price/Book compares the the price of a stock per share (easy) to the price of a company’s book value per share (a bit more difficult to figure out).
Book value technically means the monetary value accountants give a company’s overall assets minus intangible assets. In layman’s terms, the book value of a company is the accountants’ financial estimate of everything the company owns that someone can touch. This poses a few problems:
- Accountants have been known to lie on occasion.
- Book value works best for companies whose main worth originates from tangible assets.
Let me break these down a little more:
- Accountants lie (sometimes) or sometimes get it wrong: Accounting is an incredibly difficult, complex job. People can sometimes do awful things out of pride and need to avoid humiliation, and accounting’s complexity makes it very easy to hide a company’s problems for years. Unfortunately, fudging numbers only aggravates everyone’s problems exponentially. Fudging numbers also means that the book value of a company needs to be taken with a coarse grain of salt. Also, accountants can inadvertently overvalue assets which, as you probably guessed, greatly affects the book value of a company. With all that being said, don’t assume that if a company’s P/B is below 1.0, that the market has gone crazy and that a company could sell for more on the auction block than the company could sell at the New York Stock Exchange. The book value could be dead wrong, and the market usually can sniff this out long before you or I ever will.
- Book value doesn’t work with intangible assets:
When accountants value a company based upon something intangible (such as a brand or a patent) the book value of a company is greatly reduced, which greatly increases the P/B ratio. Coca-Cola’s P/B is 5.4. Anyone would consider this P/B high if Coke’s main assets were found in warehouses. On the contrary, Coke’s main asset is its brand and image which analysts will not consider part of its book value.
These are the very basis of the Price/Book ratio. If you wanted a brief takeaway from this post, just remember that although the Price/Book can be useful, if you ever see a low Price/Book, you should become more cautious than excited because you found a deal. Always assume you are missing something about the company’s price, because you probably are.