Despite the theory, determining the real value of a company is no easy task
There are two main justifications for using it to estimate value. The first is that the book value represents what has 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.
Accounting confusion And so the cracks start appearing. The first problem is that the book value does not, 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.
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 $US33 billion ($35.7 billion) last year, but according to Interbrand, its main brand is worth $US78 billion. Even that may be on the low side if the company's $US172 billion market capitalisation is anything to go by.
Closer to home, ASX Ltd, operator of the Australian Securities Exchange, has a market capitalisation of about $6.8 billion, or a little more than twice its book value of $3.3 billion. Investors are clearly betting the whole is greater than the sum of its parts.
At the other end of the scale, we have companies such as 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 aeroplanes.
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.
In essence, Macquarie 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. 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, about $49, Macquarie's price-to-book is about 1.4, 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 is not showing the big four banks to be obviously overvalued at the moment, but they are a long way from bargain territory. As a result, we have been reducing the holdings in our model portfolios and recommend limiting total banking exposure to less than 10 per cent of portfolio value at current prices.
This article contains general investment advice only (under AFSL 282288).
Nathan Bell is the research director at Intelligent Investor Share Advisor.
Frequently Asked Questions about this Article…
The price-to-book (P/B) ratio compares a company's market value to its book value. Calculate it by dividing the company's market capitalisation (total share value on the market) by its net asset value (total assets minus liabilities, aka book value).
Book value is what the company paid for its assets (less depreciation and accounting adjustments). It can be misleading because it uses historical costs, may understate assets like property, omit valuable intangibles such as brands, and overstate the value of plant and machinery in a declining industry.
Intangible assets such as brand strength can far exceed what appears on the balance sheet. The article notes Coca‑Cola had a book value of about US$33 billion, Interbrand valued its brand at US$78 billion, and its market capitalisation was about US$172 billion — showing how intangibles and investor expectations can push market value well above book value.
The article cites ASX Ltd as trading at roughly twice its book value (market cap ≈ $6.8 billion vs book ≈ $3.3 billion). At the other end, Qantas and BlueScope Steel were mentioned as trading well below book value, with P/B ratios around 0.5 and 0.7 respectively.
P/B works best where assets are relatively liquid and capital can move quickly (low barriers to exit), which is often true for financial companies. The article uses Macquarie as an example: its P/B flashed a warning around 3.5 in 2007, it traded below book in 2009 and 2011 (share price ≈ $20), and at about $49 today it has a P/B near 1.4 — illustrating how P/B can highlight entry and warning signals for liquid-asset businesses.
The article explains that big banks’ P/B fell to about 1–1.5 in early 2009 after the GFC, then rose as share prices roughly doubled and are now around 2–2.5 (with NAB and ANZ nearer the bottom and CBA nearer the top). That suggests they are not obviously overvalued but also not deep bargains — P/B should be considered alongside other metrics and risk factors.
No. The article notes companies differ in their ability to generate returns on capital — some consistently earn above-average returns because of competitive advantages or management. P/B is a useful screen but should be used with other measures (like returns on capital, business quality and asset liquidity) before making investment decisions.
Yes. Based on current prices and P/B readings, the article says the model portfolios reduced bank holdings and recommends limiting total banking exposure to less than 10% of portfolio value at current prices.
Call 1300 880 160
Start a chat
Schedule a call
