Price-to-Book Ratio

What does it mean?

The P/B ratio is calculated by dividing the current closing price of the stock by the latest quarter's book value per share. It's also known as the price-equity ratio.

Comment

A handy measure used to assess whether a company’s share price is justified or not is the Price-To-Book Ratio (P/B ratio). The P/B ratio is calculated by dividing the closing price of the stock by the company’s latest book value per share (from its quarterly or annual statements). Many of you would be familiar with this ratio already, as it’s also commonly referred to as Price/Equity ratio.

The higher the ratio, the bigger the premium the market is willing to pay for the company above its book value. A low ratio means that either the market has got it wrong – and the share price is trading too cheaply – or that the business has little value.

If the P/B ratio is less than one, it theoretically means that the shares are selling for less than the value of the liquidated company’s assets. The company is worth more dead than alive.

Spotting dirt-cheap stocks

Investors like Benjamin Graham preferred low P/B stocks – believing that these stocks had the potential for share price gains in the future.

Sometimes the market unjustifiably punishes a stock and its share price sinks to the bottom of its price chart for a period of time. It’s true that getting onboard at these times can be a profitable strategy and that the P/B ratio can be one way of unearthing undervalued stocks.

The thing to be wary of here is that low P/B stocks can also signal that something is fundamentally wrong with the company - so tread carefully.

Shortcomings of this ratio

The book value metric isn’t foolproof. There are many traps that investors can fall into.

One of the big problems with book value is calculating a reliable figure for total assets on the balance sheet. How do you accurately estimate the value of a 50-year old building, a bunch of ageing computers, or a string of dated company cars?

Book value represents what the company originally paid for the assets, less depreciation for wear and tear.

Assets that are held on the books for a long time might be depreciated to zero, whereas assets that are relatively new might actually be worth more on the balance sheet than if they were sold outright on the market. This can skew book value enormously.

Secondly, this handy ratio isn’t too smart when you are analysing stocks with few tangible assets such as financial services firms, software/internet, technology companies and so on. That’s because the bulk of these company’s assets are in the “intangible” category, meaning that they cannot be touched and seen; items like intellectual property, patents, brand name and goodwill are not included in a company’s ‘book value’. You’ll find that share prices of such stocks will bare little relation to book value.
Book value isn’t a reliable measure for sniffing out companies that are carrying too much debt.

Remember that book value is equal to Tangible Assets less Liabilities – so when a company’s liabilities are especially high, the Book Value of the stock will be low, sometimes negative. A low book value means our P/B ratio will be artificially high.The big plus with the price-to-book value ratio is that it’s a simple valuation method that can employ in your analysis. By combining book value analysis with other valuation tools such as high return on equity (ROE), you’ll be well on your way to spotting real bargains before the rest of the market.

PEG ratio

What does it mean?

The Price/Earnings to Growth (PEG) Ratio adds expected growth to the the Price/Earning ratio equation as follows:

PEG Ratio = P/E Ratio/Earnings per Share (EPS) Growth

Comment

The EPS growth number is provided by the company and is their forecast of how much additional earnings they anticipate in the coming reporting period.  Although nowhere near as widely used as the basic P/E Ratio, many financial experts feel the PEG gives a better measure of whether the share price is undervalued or overvalued. 

A PEG under 1 means the shares have the potential to beat the market’s current valuation of the shares.  High PEG Ratios are clear indications the shares are currently overvalued. 

The company supplies the projected annual growth rate and this is one of the drawbacks of this ratio – it is an estimate from a less than objective party.  However, few companies overestimate growth rates as their shares can be severely punished if they miss the target.

Peter Lynch popularized this ratio and its meaning – a fairly priced share is one where the P/E ratio equals its growth rate.  It follows that if a PEG of 1.0 represents a fairly priced share; anything under 1.0 represents a potentially undervalued share and a buying opportunity.

Debt to equity

What does it mean?

The Debt to Equity Ratio tells you the percentage of the company’s capital that came from creditors versus shareholders.  The formula for calculating the Debt to Equity Ratio is as follows:

Total Liabilities / Shareholder Equity

The Debt to Equity Ratio is a measure of how much a company relies on “other people’s money” to operate versus how much it relies on its own money – shareholder equity.

Comment

Lower numbers here mean a company is using less leverage, or debt, to operate.

Although larger companies can generally handle larger debt loads, the D/E Ratio taken in isolation doesn’t tell you anything about possible trends in the use of debt.  Has the company’s debt been steadily increasing over the past years?  

If so, when you couple a relatively high debt with a relatively low liquidity, you could be looking at trouble if business conditions take a dramatic turn for the worse.

EBITDA

What does it mean?

EBITDA = Revenue - Expenses (excluding taxes, interest, depreciation and amortisation)

Comment

It’s often said that the accounting term EBITDA shouldn’t be trusted as a gauge of the financial health of a company. When management emphasise EBITDA rather than net income, you have to ask the question – are they hiding something?

Last week we looked at EBIT, or earnings before interest and tax. This week we take depreciation and amortisation out of the equation as well, coming up with EBITDA - earnings before interest, taxes, depreciation, and amortisation.

Many criticise EBITDA because it doesn’t take into consideration important business costs and can therefore overstate a company’s profitability. EBITDA doesn’t include cash payments to cover interest on debt, taxes, depreciation on equipment and amortisation. Critics of EBITDA argue that it’s a prettied up earnings figure that makes a company look healthier than it really is.

It’s often said that the accounting term EBITDA shouldn’t be trusted as a gauge of the financial health of a company. When management emphasise EBITDA rather than net income, you have to ask the question – are they hiding something?

Last week we looked at EBIT, or earnings before interest and tax. This week we take depreciation and amortisation out of the equation as well, coming up with EBITDA - earnings before interest, taxes, depreciation, and amortisation.

Many criticise EBITDA because it doesn’t take into consideration important business costs and can therefore overstate a company’s profitability. EBITDA doesn’t include cash payments to cover interest on debt, taxes, depreciation on equipment and amortisation. Critics of EBITDA argue that it’s a prettied up earnings figure that makes a company look healthier than it really is. 

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