Nov 08, 2010
Tags: Corporate Finance, Financial Modeling, Financial Modelling, Financial Model
We are going to run through a few valuation multiples in the next few posts that are used to compare different companies, and the different strengths and weaknesses of each multiple for analysing companies. The ratios we will look at are the P/E, P/B, P/Sales, PEG and EV/EBITDA ratios. Next up is the P/B or Price to Book ratio.
The Price to Book ratio compares the current share price to the equity capital backing per share. For instance, if a company has a market capitalisation of $200m and in their Financial Statements the balance sheet says there is $100m in Equity, this means the company is trading on a P/B ratio of 2.00x.
A high P/B ratio can be justified if a company is able to produce a return on equity (NPAT divided by book value of equity) well above its cost of equity capital. For instance, if you are able to invest $100 in a business that generates $15 worth of net profit every year, and an investor comes along who has a 10% cost of equity capital, then you may be able to sell the business to them for $150 despite having only invested $100. In this case the high return on equity (15/100 = 15%) compared to the cost of capital (10%) means that the business "trades" at 1.5x book value. A high growth company will also often trade well above book value as the anticipated future returns on equity provide a net present value above the amount invested in the company.
A low P/B ratio is often justified for companies that do not generate enough profit to satisfy their cost of capital, or for companies that are expected to experience a decline in profitability. For example if you purchase a house for $100k that used to yield $10k in rent per annum, then the rental yield fell to $7k per annum, all else equal you should expect the value of the house to fall to $70k despite having invested $100k initially, in which case the house may "trade" at 0.7x book value.
Strengths of the P/B ratio include:
- More stable than the P/E ratio, especially for cyclical companies with volatile earnings;
- Easy to assess relative value and there is an intuitive multiple of 1.0x above or below which means you are paying more or less (respectively) for the business than the previous owner has invested;
- Easy to compute and does not rely on forecasts to measure;
Weaknesses of the P/B ratio include:
- It is purely a historical ratio so it tells nothing about the future prospects of the company;
- Is not particularly useful for companies that are highly leveraged or with negative equity;
- Assumes the historical asset values shown on the balance sheet are a good representation of current value. As such it is susceptible to over-representing the safety of companies that could potentially write-down the value of assets or need to sell assets at a loss.
Contributed by Paul Mason