How to look at price-to-book

Perhaps the simplest valuation tool in the investor’s toolkit is the price-to-book ratio. You get it by dividing the total value of a company’s shares on the market (its market capitalisation) by the value of all the assets on its balance sheet, less liabilities (its “net asset value” or ‘book value’).

There are two main justifications for using it to estimate value. The first is that the book value represents what’s been paid by the company for all its stuff, so it might at least be an indication of its value – after all the company could flog it all and give the money back to shareholders.

The second justification is rather more esoteric, though it amounts to the same thing. The theory goes that the book value is the base of capital from which a company makes its money, and since competition should ensure that all capital should make the same returns (at least as adjusted for risk), then the sum of a company’s capital represents its value to shareholders.

And so the cracks start appearing. The first problem is that the book value doesn’t in fact represent the value of a company’s assets; it represents what the company paid for those assets, less an arbitrary charge for wear and tear over the years, and plus or minus the odd bit of accounting confusion.

Big brands

So you have to be careful about the assets you include in your book value and the values you give them. Plant and machinery dedicated to a declining industry might have a much lower value than that stated on the balance sheet. Some assets, such as property, might be understated, and some valuable intangible assets, such as brands, might not even show up at all.

The Coca-Cola Company had a book value of US$33bn last year, but according to Interbrand its main brand is worth US$78bn. Even that may be on the low side if the company’s US$168bn market capitalisation is anything to go by.

Closer to home, ASX Ltd, operator of the Australian Securities Exchange, has a market capitalisation of about $6.7bn, or twice its book value of $3.3bn. Investors are clearly betting that the whole is greater than the sum of its parts.

At the other end of the scale, we have companies like Qantas and BlueScope Steel, which are priced well below the sum of their parts – at price-to-book ratios of 0.5 and 0.7 respectively. Investors are clearly reckoning that they won’t make satisfactory returns from all that capital stored up on their bloated balance sheets – and we wouldn’t argue.

Which gets us to our second problem – which is that companies and investors most definitely don’t all make the same returns. Some companies consistently make returns far above what others achieve, either because of competitive advantages or good management, or both. Economic theory says these factors should be ironed out over time, but in practice they can hang around for ages – particularly where the capital has been tied up in the likes of steel mills and airplanes.

Liquid assets

So the price-to-book ratio works best where ‘barriers to exit’ are low, so that capital can move quickly and easily from where returns are low to where they are high. Financial companies are probably the best example and Macquarie Group is a case in point.

Macquarie essentially comprises a pile of relatively liquid assets, with a bunch of smart people trying to direct it to where it can earn the best returns, for an acceptable level of risk.

Back in 2007, when Macquarie’s share price was nudging $90 the price-to-book ratio would have flashed you a warning sign with a level of about 3.5. But it would also have showed you the way in 2009 and 2011, when Macquarie was priced below book value with its share price around $20. Now, at around $45, Macquarie’s price-to-book is around 1.3, making it a solid hold.

The big banks make higher returns on capital than Macquarie, and can arguably justify higher price-to-book ratios.

In early 2009, in the aftermath of the global financial crisis, their price-to-book ratios fell to a range of about 1 to 1.5 (with Commonwealth Bank and Westpac near the top and NAB and ANZ near the bottom).

Since then their share prices have roughly doubled – and their price-to-book ratios are now back to around 2 to 2.5 (again with NAB and ANZ near the bottom and CBA at the top). This is still some way below their pre-GFC peaks – Westpac hit 3.7 and CBA reached 3.3 in late 2007 – but Beirut isn’t a safe place just because it isn’t Kabul.

The price-to-book ratio isn’t showing the big four banks to be obviously overvalued at the moment, but they’re a long way from bargain territory. As a result, we’ve been reducing the holdings in our model portfolios and recommend limiting total banking exposure to less than 10% of portfolio value at current prices.

Note: Our model Growth Portfolio owns shares in ASX and Macquarie Group. Our Income Portfolio owns shares in ASX, CBA and Westpac.