How much are you paying for the stock?

How much are you paying for the stock?

In the previous article, we discussed the Price to Earnings Ratio (PE Ratio). However, as mentioned previously, this financial ratio cannot be applied for those companies making losses.

To perform a valuation, another metric to be considered is the Price to Book Value (PBV).

As its name suggests, it is a financial ratio used to compare a company’s book value to its current share price. Let’s look at the formula of the PBV:

PBV = Stock Price ÷ Book Value per Share

The book value is derived from the company’s total assets less its total liabilities, or also known as net assets. It is also considered to be the total equity for the ordinary shareholders.

Similarly like PE Ratio, PBV is used to value a stock, whether it is undervalued or overvalued when compared to the same industry as a benchmark.

In addition, this financial ratio varies a fair amount by industry. Some industries will have relatively high PBV while in others it is relatively low.

For companies under the same industry, a company with a low PBV could mean the price is currently undervalued, or something is fundamentally wrong with the company.

Conversely, a company with a high PBV could mean the price is currently overvalued, or imply that the future earnings outlook is bright.

For example: Company A, Company B and Company C are operating the same type of business in the financial services industry. Their stock price, book value per share and PBV are summarised as below:

Stock Price (RM)

Book Value per Share (RM)

PBV (x)

Company A

4.00

2.00

2.0

Company B

4.50

2.50

1.8

Company C

3.96

1.80

2.2

Industry Average

2.0

Let’s assume there are only three financial services companies listed in the stock exchange and they have the same earnings outlook. Based on the data above, the average PBV for the industry is 2.0 times.

For Company A, it is considered fair value, as the ratio is at par with the industry average.

For Company B, it is considered undervalued, as the ratio is lower than the industry average.

For Company C, it is considered overvalued, as the ratio is higher than the industry average.

Based on this example, it is worthwhile to invest in Company B as the investment risk is relatively lesser compared to Company A and Company C.

In the case of a company with a PBV of less than one, this implies that the company is not running up to par, and along with other factors, could potentially lead to a hostile takeover.

Conclusion

Like the PE Ratio, the PBV is useless on its own unless you compare it to other companies in the same industry.

In addition, a low PBV is not always indicative of an undervalued company, and a relatively high PBV is not necessarily overvalued.

The PBV is best used with another financial ratio, a useful companion metric which will be discussed in the next article.