Generally speaking, all of a company’s balance sheet data are recorded at historical cost (adjustments for currency fluctuations for multinational firms are he only exception I can think of this early in the morning).
If this accurately reflect’s today’s values, and sometimes this can be an IF, then
…book value is an accurate indicator of the market value of shareholders’ ownership interest in the firm.
That means that price/book (share price divided by book (shareholders equity) value per share) can be an indicator of over/undervaluation. In particular, if a company’s shares are trading below book, then it could potentially be broken up and sold at a profit.
We can also use return on book value (yearly net profit divided by book value) as a way of assessing management’s skill in using the assets it controls to make money. This can be a particularly useful shorthand in the case of, say, financial firms, which tend to have fingers in a lot of pies and to disclose little about many of them.
–price/book is not a linear or symmetrical measure.
On the one hand, a basic tenet of value investing is that when the return on book is unusually low either the company’s board or third parties will force change. So weak companies may trade at smaller discounts to book than one might think they deserve.
On the other, strong performing firms will likely trade at premiums to book. However, the amount of the premium will depend both on the state of “animal spirits” and more sober judgments about the sustainability of above-average results.
—return on book vs. return on capital. Return on capital is the same kind of ratio as return on book and has the same intent–to assess how well management is using the assets it is entrusted with. The difference is that ROC factors in any long-term debt a company may have.
Return on capital is defined as: (net profit + after-tax interest expense) divided by (long-term debt + shareholders equity).
Return on capital and return on book value are the same if a company has no long-term debt. Return on capital is typically lower than return on book if a company has long-term borrowings, debt capital usually costs (a lot) less than equity capital.
using return on capital
ROC and the spread between ROC and ROB can be important. We should think of ROC as the profitability of the business enterprise and the difference between it and ROB as the return on financial leverage.
For instance, for a given firm, the ROC may be 10% and the return on book (equity) 15%. The difference, 5 percentage points, is the result of “financial engineering,” or the leveraged structure of the company. Those figures may be ok (and, for the record, I’m not against leverage per se). But if the ROC is 2% and the ROB is 12%, virtually all the profits of the firm come from financial leverage–not from the underlying business. That’s a risky situation, in my view–one that owners should be aware of.