The Myth of Book Value
Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Price to book ratio is a metric usually used by investors to determine if a stock price is undervaluing the asset value of the company. However, one of the problems with this is that the P/B ratio can other be incredibly misleading. For example many tech firms like HP and Intel will often have patents on their balance sheets. These will account for a good portion of the company's assets. The same can also be said for financial stocks that can have huge amounts of assets on their balance sheets that could have no intrinsic or tangible value. Goodwill is another asset that can bulk up a balance sheet with almost no tangible value.
These intangible assets can be distorting to the P/B value. As they have no real intrinsic value, for example, a financial instrument marked on a bank’s balance sheet for $1 million – in the worst case scenario, this will be sold for significantly less than $1 million. The same can be said for patents, as with so many tech firms, if they become insolvent, people will pay a little as possible to get their hands on the patents.
A tangible asset, on the other hand, actually has a solid retail value. Let’s take an example. A car is worth $10000 – that is how much it cost to make, that value can be proved. On the other hand, if I invent a magic umbrella and patent, it how much is that patent worth? Who knows?
So, a more reliable ratio I like to use is the price to tangible book ratio, although this ratio usually requires more calculation.
P/B ratio = Share price divided by net asset value per share.
P/Tangible book = Share price divided by net tangible asset per share.
To explain this in more depth I screened the S&P 500 for the stocks with the lowest P/B values.
The screen returned 63 companies with a price to book ratio of less than 1. This included 37 Financial and 4 Tech companies.
Now, this is where it gets complicated. It is impossible to value financial firms on their book value in my opinion, due to the fact no one knows really how much everything is worth. On top of this, P/B is supposed to let you know how much the firm is worth in the worst case scenario. In a banks worst case scenario, everything would become worth much less than it is now.
So rather than writing off financial stocks totally, I screened the results for a Price to Cash ratio of less than 1.
I came up with two results. They both demonstrate how much variation there is between P/B and P/Tangible book:
1. E*TRADE Financial Corporation (NASDAQ: ETFC)
2. Bank of America (NYSE: BAC)
These were the only financial stocks that passed my price to cash test. They both have significant differences between their book and tangible book values. They demonstrate my point well. For example, Bank of America’s asset value is $20.40 a share; that is a difference of over 200% from the current price. However, BAC’s only reliable tangible assets are worth $13.48 a share, significantly less. The next 3 companies with a P/B <1 are:
3. NRG Energy (NYSE: NRG)
4. WPX energy (NYSE: WPX)
5. Alcoa (NYSE: AA)
These five companies all demonstrate how much variation there can be between the price to book ratio/net asset value of a company compared to the actual tangible asset value.
Price to book is supposed to show investors how much the company is worth in the worst case scenario. It should give investors an idea how much the assets of the firm would be worth if the firm was liquidated and assets sold off. However, I doubt in most cases you would get more than the tangible book value.
This is why investors should always be wary about discounts to book. Take a closer look and find out how much the tangible value is actually worth!
Data Source: www.marketwatch.com.
RupertHargreav has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!