By: Tim Bennett
17.04.2019
17.04.2019
Is one of investing’s oldest valuation measures broken? Tim Bennett puts the price to book ratio in the dock in this week’s short video.
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Is it game over for one of investing’s magic numbers?
The price to book ratio, for decades one of the great value investing magic numbers, is under attack. Why, and what should investors make of it now?
Background
Critics of the price to book ratio say that its time is over – the world has moved on and this key ratio has not kept pace. However, as with most things when it comes to investing, I think the truth is rather more nuanced.
A quick reminder
The “P/B” ratio compares the current share price to the book value per share of a firm, based on dividing its balance sheet net asset value by the number of ordinary voting shares in issue.
As a rule of thumb, a result below 1 is considered cheap in value investing terms, because it suggests that you can buy the assets of the firm for less than they are worth by purchasing the firm’s shares. Conversely, anything above 1 is traditionally considered expensive.
The critics
Whilst the theory is neat, critics say the ratio is fundamentally flawed in today’s markets. They cite several problems;
- It doesn’t work where you have a firm, such as McDonalds, that has a negative net book value
- The failure of value firms to deliver outperformance, despite being supposedly cheap by this measure, points to its irrelevance
- It suffers from three technical drawbacks as a measure; an inability to deal with intangible assets, research and development costs and share buybacks
These problems are revealed by looking at some of the firms that would be excluded from a portfolio on the basis on this ratio;
My thoughts
The critics of this number do have a point – it is not suitable in all circumstances, especially where firms have a very low book value thanks to the non-recognition of certain intangible assets on their balance sheets, for example. However, that is not the same as saying that it is redundant. As with all ratios, judgement is needed to decide where it can be used most usefully. In sectors with a high book of assets, such as property development, investment trusts and banks, it is still a good guide to relative value. So, whilst is may not be the perfect magic number, it should still be in the list.
To find out more
A good article on this subject can be found here;
You may also wish to discuss this further with an Investment Manager.
