Relative Valuation Part 3 – Price/Book Ratio

Relative Valuation Part 3 – Price/Book Ratio

This column is written by @gordon_ong.
-Gordon has a demonstrable interest in equity investments, financial markets, and negotiating deals. As @NTUInvestmentClub president, he has an understanding of what factors drive an organisation’s success.

Another way of comparison is the P/B ratio. P/B is a way to compare the price you pay compared to the value of the company’s assets. P/B is best used for asset-heavy companies and capital intensive companies, such as manufacturing, finance and construction.

P/B formula and determinants

Understanding the P/B number

What P/BV measures is the market expectation of growth opportunities. P/B greater than 1 means that the market believes that the book value can be utilised to earn supernormal returns (high ROE), hence price the company at a higher value than the amount on its books. P/B is hence determined by the differential between ROE and required return. If ROE > required return, P/B > 1.

If P/B < 1, the market either expects that the company will generate low future ROE, and/or that the company’s book value is inflated.

The market may be wrong. If you believe that two companies have similar future growth opportunities, yet one is trading at a much lower P/B than the other, it is possible that that company is relatively undervalued compared to the other.

Understanding Book Value

What is Book Value? Book Value is total assets minus total liabilities, you can think of it as the value of the company that the shareholders own. However, take note that Book Value is not Market Value. The total assets and total liabilities are recorded not at market price, but rather the value on the accounting books. This is a very important distinction.

Problems of using Book Value, and hence P/B as a yardstick


Why is it an important distinction? Simply put, a company can decide to value assets at historical cost or fair value.

Let me give you an example. Let’s say Gordon Property Flippers Capital (GPFC) bought a house at $50,000 in 2005, and it chose to recognise the asset at historical cost. The market value of the house is now $10m. However, the book value of the house is only $50,000. The market realises this and price GPFC at a high price. P/B will look extraordinarily high. When using P/B, you must be very aware of the accounting method the company uses to value assets.

Another concern is that, in Singapore (as well as elsewhere), around 80% of Assets are stated at Fair Value, while only 10% of Liabilities are stated at Fair Value (most are stated at cost). Source: KPMG http://www.straitstimes.com/business/vast-…. Hence, Book Value numbers are inflated and you commonly see cheap P/B valuation of 0.7-1x in SGX.

Another concern is that some part of the Book Value consists of intangible assets. Intangible assets are, literally, assets that are intangible in nature. Only those that are recognised by accounting standards are included in the accounting statements under assets (and affect Book Value) Some of the recognised intangible assets include trademarks, patents etc. if they fulfil certain accounting criteria (identifiability, control, future economic benefits, probable, measured reliably).

One immediate concern that jumps out is – how can anyone put a dollar value to such intangible stuff like patents? Simple, just like any other asset, call in an independent expert for valuation! Apart from CPA, CFA and CAIA, there even exists a certificate called Certified Valuation Analyst (CVA). Investopedia has some basic information about valuing patents, http://www.investopedia.com/articles/funda…. In short, it’s a very subjective matter, and will affect Book Value.

In my opinion, the most controversial form of intangible assets that affects the Book Value is purchased goodwill. Purchased goodwill arises when your company acquires another company. If the price that your company pay for the acquisition is higher than the fair value of its net assets, the difference in price is recognised as purchased goodwill, an actual asset on the company’s balance sheet.

If CityDev acquire Gordon Property Flippers Capital (GPFC) for 15m, and the net asset value of the GPFC is 10m, CityDev will recognise a purchase goodwill of 5m. But if CityDev is bad at negotiations and buy GPFC at 50m, they will recognise a purchase goodwill of 40m. In other words, the existence of purchased goodwill as an “asset” is only backed by management’s capability of valuing companies. If management has a history of overpaying for acquisitions, or even worse, had to write-off purchased goodwill in the past, purchased goodwill is an unjustified item that inflates the book value and artificially depresses P/BV. High purchased goodwill can indicate management’s subpar judgment and negotiation skills, rather than the true value of the acquired company.

P/Tangible BV

One solution is to use P/Tangible BV. Tangible Book Value, as the name suggests, removes all intangible assets from consideration. By using this multiple instead, you are making the conscious decision to ignore all intangible assets and their benefits to companies.

Again, the choice between using P/B and P/Tangible BV is whether you believe that intangible assets valuation is so flawed that ignoring them entirely provides a better means for comparison. This depends on the characteristics of the comparable companies. Let’s say we have two manufacturing companies, Company A and B. However, Company A has a patent that allows it to manufacture a certain high-value product. If you believe that this patent is very useful in generating future economic benefits AND the patent valuation is reasonable, you will use P/B. If you believe that this patent is valued way too highly on the accounting books, you will use P/Tangible BV.

P/Tangible BV also gives an advantage in that you can use it as a proxy for the company’s liquidation value. Intangible assets cannot be easily sold at near-book prices, and in the event of a liquidation, may be useless. Note that in the case of a bankruptcy and fire-sale, even Tangible assets might be sold at below accounting figures. Hence, P/Tangible BV only gives a rough estimation of the company’s liquidation value.

Conclusion

Now that I have explained several valuation multiples from the equity perspective, next post will be about the capital structure, the difference between firm valuation and equity valuation, and the need to match numerator and denominator for accurate multiples. I will also cover a few common firm ratios.

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