A value metric that many investors use in their initial stock screen is the price to book or P/B ratio. It relates a company's current share price to the value of its net assets. The thinking is that the lower the ratio the better the value deal they get when buying a company's shares.

Book value, in the sense investors use the term, is what a company owns minus what it owes. It's the amount of capital shareholders have tied up in the company. Hence it's also referred to as shareholders' equity. Another way to think of it is: how much money would shareholders have to supply in order to reproduce the company?

Stock investors have long associated the value of a company's shares with the value of the net assets the company holds. In the 19th century the broad belief was that this association was one of equality; that is, the company's worth to the shareholders is the value of its hard assets less any debt. This view isn't widely held today — the potential for future earnings is what drives stock prices now. But book value is still an important consideration when it comes to valuation. For example, book value per share is used as an input to several valuation formulae, and it still provides a value anchor we shouldn't lose sight of when share prices are bid to crazy bull market heights.

That Warren Buffett likes this metric can be seen from the opening comments in his 1984 Chairman's letter to Berkshire shareholders:

As we discussed last year, the gain in per-share intrinsic business value is the economic measurement that really counts. But calculations of intrinsic business value are subjective. In our case, book value serves as a useful, although somewhat understated proxy.

Buffett has continued to place significant importance on this metric, as was demonstrated in September 2011 when he announced, for just the second time under his stewardship, that Berkshire was prepared to buy back its own shares at a price directly related to its book value. He didn't specify a price at which Berkshire would buy back its shares; instead he announced the offer would remain open at any price up to a 10 per cent premium to book value.^a

Clearly Buffett sees a strong link between the intrinsic value of Berkshire Hathaway and its book value. But, as Buffett points out, it's an association, not equality. Book value can either understate or overstate a business's economic value — that is, the value determined from an assessment of its earnings potential.

WHAT IS BOOK VALUE TELLING US?

Book value is listed in the company accounts in the Statement of Financial Position (balance sheet). Like the Income Statement, the Statement of Financial Position is constructed according to lots of accounting rules. This means, despite the best intentions of the accounting bodies, the rules deliver figures that can at times be removed from economic reality. If you want to explore some of the principal digressions, I've outlined them in appendix A. But rather than listing them here I'll demonstrate how this can occur using a real example.

Coca-Cola Amatil (CCL) is listed on the Australian Securities Exchange. It represents Coke's bottling interests in Australia, New Zealand, Papua New Guinea, Samoa, Fiji and Indonesia — a pretty strong and stable business, one would expect. Yet between 2004 and 2005 its book value plummeted by a staggering 54 per cent. The news would have worried shareholders terribly, until they realised what caused the drop.

The company's accounts were impacted by the adoption of Australian International Financial Reporting Standards (AIFRS). In 1999 CCL's management put a commercial value on its distribution licences and then reported this as an asset on the balance sheet, and it was indeed a very valuable asset. But the new AIFRS rules didn't allow the recognition of internally generated intangible assets, so in 2005 CCL was forced to remove this $1.9 billion asset from its balance sheet. This halved the reported shareholders' equity despite there being no change in the company's commercial value. Overnight the P/B ratio doubled, as did the ROE and gearing ratios. It was exactly the same company but now it had very different value and debt metrics.

As an investment it was no different from before, yet its changed metrics meant it now fell outside many stock screens that previously would have caught it.

RELATING BOOK VALUE PER SHARE TO MARKET PRICE

Let's take a closer look at the influences on the P/B ratio using the same formula we used to look at the PE ratio.

where:

• P = current market share price
• ROE = anticipated return on equity
• g = anticipated annual growth in earnings
• B = book value per share
• r = required rate of return (discount rate).

So the three underlying drivers of the P/B ratio are the anticipated ROE, the required rate of return and the anticipated earnings growth (g). Note the use of the word ‘anticipated' in relation to the ROE and earnings growth. The market always values stocks in anticipation. Driving these expectations, and in the absence of a crystal ball, investors and analysts are very much influenced by the conditions experienced by the company at the time the judgement is being made, which means companies currently achieving high earnings growth and a high ROE tend to trade on a high P/B ratio. Investors need to judge whether these will be maintained, because if they aren't then the share price is likely to fall. That's why value investors go on so much about seeking out companies with an enduring competitive advantage.

Note that the above formula can also be adapted and used as a valuation formula. By multiplying both sides of the equation by the book value per share (B) we derive:

WHAT IS A LOW P/B RATIO TELLING US?

James O'Shaughnessy, whom I mentioned back in chapter 13, wrote that over the long term the market rewards stocks with low P/B ratios and punishes those with high ones.⁶¹ But using the same argument I delivered regarding the PE ratio, it's risky to assume this will always be the case. There are plenty of reasons that stocks trade on low P/B ratios, and the formula above gives us an insight into what they might be. For example:

• A stock's ROE could be low.
• Its growth prospects could be low.
• The company could be in financial difficulty.
• The market could believe the book value is understated in the accounts.

Or finally:

• The share price could actually represent good value.

All of this means you can't base any decision regarding a stock purely on its P/B ratio. You can't escape the need to have a deeper understanding of the company itself and the business environment within which it operates. Then you can develop an appreciation of whether the P/B ratio the market has tagged it with is appropriate.

Chapter summary

• The price to book (P/B) ratio is a popular metric in stock screening.
• The P/B ratio relates market price to book value per share.
• In the 19th century the value of a company was typically equated to its book value.
• The book value listed in the company accounts doesn't always reflect economic reality, and the experienced analyst will make adjustments to account for this.
• The three underlying drivers of the P/B ratio are the anticipated return on equity, the required rate of return and the anticipated earnings growth.
• In the search for value, low-P/B stocks are sought, but low P/B should not be relied upon as the sole metric of stock selection.
• Companies with a low P/B are more attractive if they also have high and enduring ROE.