The price-to-book ratio

This is a ratio that is less often heard in the financial times. It is made up of the price, which is the price the whole company is selling for on the market, and the book value, which is simply assets minus liabilities, or equity as stated on the balance sheet. This ratio measures how much we are actually paying for in multiples of the book value as stated in the balance sheet.

The price for a whole company that a market is willing to pay for is called the market capitalisation. The formula for market capitalisation is simply:-

Market Capitalisation = Price per share X No. of shares outstanding

This makes up the price portion in the price-to-book ratio. When a person wants to gain full control of a company, they have to buy all the remaining shares on the market, so as to gain a 100% ownership and control over the company.

The book value is simply what is left after all the assets are sold for, and then minusing all the liabilities of the company to arrive at what is called the net worth of the company, or equity value. What is dodgey here is that the assets stated on the balance sheet might not truly represent what the value the assets would be able to be sold for in case of a liquidation of the company, and all its assets are held up for sale. The equation for net worth/book value is:

Assets - Liabilities = Book value

Because of the representation of assets and liabilities which might not truly represent the fair worth of a company in case of a liquidation, analysts like to look at what is called the reproduction value of the business. The reproduction value of the business is simply what a competitor would have to pay to reproduce the exact same assets a business is currently earning and then minusing the business' true value of its liabilities to arrive at a more fair representation of its book value.

Coming back to value investing, Graham's style was to never pay for any asset which was worth more than 1.5 times price-to-book ratio. However, modern value-investors such as Warren Buffett is willing to pay up to 3-4 times the ratio as long as the price he pays is less than the intrinsic value of the business with a decent margin-of-safety. By textbooks standards as we learn in accounting in university, the contemporary acceptable standard of price-to-book ratio is around 2-3.