Price-to-Book Value and Determining Book Value

The P/E tells you what you are paying for a unit of earnings. The P/B is the __price-to-book value__ ratio, telling you what you are paying for—well, what's on the books. Specifically, the "B" in P/B is the book value of equity. So start with assets minus liabilities. That's equity in any accounting course, but it's more specifically __shareholders' equity__. Now if you're comparing the market price to a book price, make sure it's the same thing. The market price is based on trading of common shares.

What sort of equity wouldn't be owned by common stockholders?

Not quite. The par value and additional paid-in capital of common shares do represent ownership of common shareholders.

That's right! Preferred stock is stock. It's equity and ownership, but it's senior to common shareholder claims. So from total stockholders' equity, this has to be removed to get at the book value of equity. So does any preferred dividends in arrears. Once those are removed, then you have book value of equity. From there, divide by the number of shares outstanding, and you have book value per share. That's the "B" in P/B.

No. Retained earnings are owned by common shareholders. It's theirs to keep, in a way.

So suppose a firm has 500,000,000 shares outstanding, with the following: | Description | Value (billions of CZK) | |---|---| | Assets | 60 | | Liabilities | 40 | | Preferred Stock | 5 | The book value of equity is CZK 15,000,000,000, and book value per share is CZK 30. If the share price was CZK 36, then the P/B ratio is 1.2. What do you think is a good reason for investors to pay more than book value in the share price?

Yes!

Not quite. Assets can go up or down in fair value, depending on what they are.

No, that wouldn't be a valid reason. That new debt would still be part of measured liabilities.

These choices bring up some strengths and weaknesses to the measure. What's nice is that book values per share (BVPS) are generally positive. You don't have the problem of negative BV like you do with EPS when using the P/E. Book value is more stable, better for liquid firms, and P/B is related to returns empirically.

But it's not all good. Book value ignores human capital, ideas, opportunities, and other off-balance-sheet items. It also changes depending on reporting conventions—capitalization of costs, FIFO vs. LIFO, all of those things. And then some assets are held at historical costs, and some are held at fair value. One big issue to consider here is share repurchases. They are more popular now, and they do affect book value and therefore the P/B. Think about a firm using a bunch of cash to buy back shares. How do you think that would affect the P/B ratio?

Exactly!

No, actually it would increase.

A share repurchase reduces assets (cash), and reduces equity. The firm value shouldn't change, so you have the same "P" with a lower "B". The P/B ratio increases. There are plenty of examples of large P/B expansion during much smaller changes in the P/E ratio when share repurchases are at work. Be mindful of these things when using the price-to-book ratio. Markets determine price without a problem. Management determines book value with a lot of questions to be asked.

To summarize: [[summary]]

Par value

Preferred stock

Retained earnings

The firm has added new debt recently

Assets are mainly recorded at historical cost

Management is developing exciting new projects

It would increase

It would decrease

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