P/B Multiple

P/B Ratio

Advantages of using the price to book (P/B) ratio include:

• Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative. Thus, a P/B can typically be used when P/E cannot.
• Book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low, or volatile.
• Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Examples include finance, investment, insurance, and banking firms.
• P/B can be useful in valuing companies that are expected to go out of business.
• Empirical research shows that P/Bs help explain differences in long run average stock returns.

Disadvantages of using P/B include:

• P/Bs do not reflect the value of intangible economic assets, such as human capital.
• P/Bs can be misleading when there are significant differences in the asset size of the firms under consideration because in some cases the firm’s business model dictates the size of its asset base. A firm that outsources its production will have fewer assets, lower book value, and a higher P/B ratio than an otherwise similar firm in the same industry that doesn’t outsource.
• Different accounting conventions can obscure the true investment in the firm made by shareholders, which reduces the comparability of P/Bs across firms and countries. For example, research and development costs (R&D) are expensed in the United States, which can understate investment.
• Inflation and technological change can cause the book and market values of assets to differ significantly, so book value is not an accurate measure of the value of shareholders’ investment. This makes it more difficult to compare P/Bs across firms.

The price to book ratio is defined as:

We often make adjustments to book value to create more useful comparisons of P/B ratios across different stocks. A common adjustment is to use tangible book value, which is equal to book value of equity less intangible assets. Examples of intangible assets include goodwill from acquisitions (which makes sense because it is not really an asset) and patents (which is more questionable since the asset and patent are separable).

Furthermore, balance sheets should be adjusted for significant off balance- sheet assets and liabilities and for differences between the fair and recorded value of assets and liabilities. Finally, book values often need to be adjusted to ensure comparability. For example, companies using first in, first out (FIFO) for inventory valuation cannot be accurately compared with peers using last in, first out (LIFO).

Thus, book values should be restated on a consistent basis.