Valuing shares is a tricky business. That’s why over the decades equity analysts have developed a range of different ways to estimate how much a company could be worth. Well established approaches such as discounted cash flow and earnings multiples have been popular for almost a century and remain commonly used methods for valuing businesses. More questionable measures also exist including the price to sales multiple, revenues per user figure and (as was the case for many analysts covering cash guzzling dotcom businesses) the ever popular “finger in the air” method.
One of the least complicated ways of valuing a company is to use the price to book value ratio (also known as the P/B ratio). This simple method compares the current market capitalisation of a business with the value of its net assets (or equity shareholders’ funds) as at the last reported balance sheet date. For example, if X Company is valued at £50 million and has net assets of £25 million it would be trading on a price to book value ratio of 2 times. Investors can then use this information to ascertain if a business is under or over-valued, for example by comparing the figure to peers within the sector or to a company’s own historic P/B ratio.
The Holy Grail of price to book value analysis is identifying a company which trades on a P/B ratio of below 1, or in other words, a company whose shares are trading at a discount to the value of its net assets. The thinking behind this approach is that (as with all methods of value investing) you are finding something you can buy for less than it is worth.
Say for example the situation above is switched around and X Company has a market cap of £25 million and net assets of £50 million. The P/B ratio here is 0.5 times so buying the shares could effectively be like buying a tenner for the price of a fiver. I say “could” because a company’s asset value may be overstated on the balance sheet. Or the market might have a different opinion as to what the assets are really worth.
Of course, the P/B ratio should not be used in isolation.
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