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Price-to-Book and Value Investing

By on April 12, 2012 in Money

Price-to-Book and Value InvestingWarren Buffett learned his core investing principals from the highly successful value investor, Benjamin Graham. One of the core principals that made both men (and their firms) incredibly wealthy was that of price-to-book ratio and how it integrates into value investing.

What is Value Investing?

There are two main ideas about investing in individual companies: to go after fast growing companies that will continue to grow (and thus the stock price will go up) or to find companies whose shares have been beaten down due to poor management or results in hopes that they will recover. The first method is growth investing, the latter is value investing. Warren Buffett is a strong value investor. He invests in what he can understand, so he stays away from tech stocks and buys boring but profitable companies like insurance and soda companies.

What is Price-to-Book?

Price-to-book is a ratio that shows, as a percentage, the difference between the stock market’s value of the company to the book value of the company.

Book value is the value of the company “on the books”; that is, on the balance sheet. Book value is the difference between the company’s assets and its liabilities. The question is if you had to liquidate the company completely and sell off literally everything it owns, would you be able to cover all of the liabilities and debts? That value is the book value.

How to Calculate Price-to-Book Ratio

Price-to-book ratio then contrasts the stock market’s value of the firm to the book value. To do this, the book value is divided by the number of shares outstanding as listed on the balance sheet. This gives a book value per share which is then contrasted with the current share price on the stock exchange.

To calculate price-to-book ratio (also known as P/B ratio), simply divide the current share price by the price-to-book (per share) price. For example, a company with $50 million in assets, $40 million in liabilities, 5 million shares outstanding, trading at $10 per share has a P/B ratio of 5.0. ($50 million minus $40 million = $10 million in book value. Divided by 5 million shares outstanding is $2 per share in book value. $10 per share on the market divided by $2 per share in book value = a P/B ratio of 5.)

Why is P/B Ratio Important to Value Investors?

The price-to-book ratio is an easy way to tell how undervalued a company is. If a firm is trading for only 75% of its book value on the stock market an investor, in theory, could buy all of the shares of the company, sell off all of the assets for top dollar, and generate a 25% return.

This usually means the market believes either the firm is overstating its assets (as some banks with mortgages on their books might be right now), understating its liabilities, or in general believes the firm is so poorly run that the return generated on the assets the firm has won’t be worth as much in the future.

Obviously there are risks to investing in companies with low P/B ratios, especially those under 1.0 (less than 100% of book value). The market is very efficient and it isn’t a real secret that the company is undervalued compared to its assets. The discounted share prices are there for a reason: bad news about the company or industry, poor management, poor results, and so on. But value investors look for good companies that can return to their former glories. A value investor sees a company trading for less than its book value as something with a built in margin of safety. At the end of the day if the trades doesn’t work out, the company can be liquidated and investors will get a return on their investment. That margin of safety is not often found in stocks, and is a draw for investors, especially if they can get a dividend to go with the cheap share price.

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