price to book: a traditional, but flawed, tool

what book value is

It’s another term for shareholders equity, the financial accounting tally of the total amount of money shareholders, as owners have provided management to work with–through purchases of stock from the company and through profits retained in the business.  It’s called “book” value because the figure is taken from the company’s accounting books.

An example:

We form Ace Investment Advice (AIA) by selling 100,000 new shares to backers at $10 each.

Our balance sheet is simple.  We have cash of $1 million on the asset side, no liabilities and net worth (aka shareholders equity or book value) of $1 million, or $10 a share.

Let’s say AIA earns $200,000 in its first year of operation and distributes nothing to shareholders.  At the end of the year, net worth/book value is $1.2 million, or $12 a share.

how it’s used

return on equity and management skill

AIA management took $1 million and earned $200,000 with it during the year.  That’s a return of 20%  (yes, if management earned that money in a linear fashion through the year, the number is slightly lower, but let’s not worry about that refinement here).

I can compare this performance to what the management of similar firms has accomplished to see whether that’s good or bad.

price to book

I can also compare this performance with that of the managements of all other publicly traded companies, to see if this is a stock I should want to own.

If management is regularly able to achieve a 20% return on the shareholder funds, I probably do want to be a shareholder.  And I’m likely to be willing to pay a premium to book value–let’s say 1.5x book, or even 2.0x book– to become one.

On the other hand, if AIA consistently earns a 2% return on shareholder funds, then the stock doesn’t look attractive to me at all, at least not at book value.  Maybe I only want to pay 50% of book value for it.  And even then I’m probably betting that the board of directors will find better management to run the firm or that an acquirer will be attracted by the discount to book value and make a bid to take it over.

More on Monday.








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