Is the price to book ratio the nearest thing to a holy grail?
You be the judge: Tweedy, Browne Company LLC published a report that showed a successful stock market strategy (page 3) based on the price to book ratio with phenominal results. The Shares And Stock Markets Blog uses the price to book ratio during the valuation process.
Today’s post will show you what the price to book ratio is, how to calculate it and how to use it for better investing results.
What Is The Price To Book Ratio?
The price to book ratio is the first financial ratio I look at when analysing a company for potential investment.
The price to book ratio is a measurement of how much the shares are trading at compared to its book value.
For a quick tutorial on what book value is, take a look at ‘How To Value A Company; The Lazy Investor’s Guide’
The key aspect of book value is that is is a real world, up-to-date value of a company based on what the company owns such as cash in its bank account and the items in its invesntory.
All companies have debts and so these are taken into account when calculating book value.
For example, in the post ‘How To Value A Company; The Lazy Investor’s Guide’, Tesco (TSCO) had a book value of £13,183 million.
As a reminder, a shorthand method to calculate book value is to find the total equity figure (or total stockholders’ equity for the US) found right at the bottom of the balance sheet and take away (minus) goodwill and intangibles, found at the top of the balance sheet under non-current assets.
Just for completeness, I have provided the Tesco balance sheet below. You can calculate book value for yourself. If you do not have time move on; you can always try it at a later date.
The Diluted Weighted Average Number of Shares
The diluted weighted average number of shares is jargon for the average number of shares that Tesco issued to the stock market during the accounting period (in this case from February 2011 to February 2012).
At any time, a company can issue, repurchase or retire shares which will affect the number of shares that are issued during an accounting period.
As investors, we are only interested in the average number over this period.
Tip: in a pdf version of the financial report, press control and the letter f and type the word ‘weighted’. Keep pressing enter until you get you to the diluted weighted average number of shares in the report. It’s much quicker this way. You can also do this for terms such as ‘balance sheet’, ‘intangibles’ or ‘goodwill’.
‘Diluted’ refers to the amount of shares that have share options on them.
Share options are given to high ranking employees. They are rights to buy Tesco shares that do not yet exist and so when the time comes, high ranking employees will ‘exercise their right’ to buy or sell Tesco shares.
As investors we need not concern ourselves with the technical aspects and jargon of what share options are for now except that we need to include them in our calculation of the price to book ratio to take account of shares that Tesco could potentially issue due to share oprtion.
Tesco has given share options on 24,000 shares to employees and as investors, we have to assume that these employees will collectively buy or sell all of these shares because we simply do not know when they will do so or how many of them they will buy or sell.
From the notes to the accounts, Tesco had a weighted average number of diluted shares of 8,045 (m). This amount includes the 24,000 share options.
Calculating The Price To Book Ratio
Book value – £13,183,000 million – divided by the weighted average number of shares – 8,045,000 million – equals 1.6386575 or £1.63 book value per share.
Current share price – £3.20 – divided by the book value per share – £1.63 – equals a price to book ratio of 1.96.
How To Use The Price To Book Ratio For Better Investment Results
A price to book ratio for any company of less than 1.00, means that a company is selling it’s shares for less than the tangible assets listed on it’s balance sheet.
In other words, an investor can buy part ownership of a company at a discount to its book value.
There are of course many more aspects to the analysis process that I do before purchasing shares but calculating the price to book value is
usuallymy first step.
Tesco is selling above its book value (above a price to book ratio of 1.00). Do other companies sell their shares below their book value (below 1.00)?
And this is the cornerstone of one method of value investing analysis: looking for companies that are selling below their book value. It is how I value companies on The Shares And Stock Markets Blog.
Why Do Companies Sell Below Their Book Value?
There are a number of reasons but usually they are in some kind of trouble and could include things like:
- reduced sales or earnings
- the market believes that the future is bleak for the company
- it is going through some litigation the outcome of which is unknown and potentially extremely damaging
- involvement in a scandal
- The sector in which it operates is having a bad time as a whole
Another reason is because mainstream analysts will often miss small companies (who are more likely to sell below book value) precisely because they are small.
With the vast sums mainstream analysts have under management, they seek out larger companies who can absorb large investments.
This is one reason why smaller investors like myself have an advantage over the big guys.
I’m Busy. Is There Are Short Cut I Can Use To Look for Companies Selling Below Their Book Value?
Of course there is 🙂
ADVFN.com has a handy screener that will list shares selling below their book value. This will then give you a list of companies that you can do further research on. Their service is free.
‘How To Use ADVFN To Invest Like Ben Graham And Walter Schloss’ is a two part series of posts that shows you how to use ADVFN‘s screener using the price to book ratio and additional ratios used by these two famous investors.
Remember to double check the book value from the balance sheet if you find an interesting company using ADVFN‘s screener.
I realise that this a lengthy post (over 1,000 words) but I hope you found it useful. Calculating the price to book ratio gets easier and quicker once you have done it a few times.
Failing that, there’s always ADVFN.
Thanks for reading The Shares And Stock Markets Blog and good luck with your investments.
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