Chapter 9: Book Price and Valuation Ratios

Introduction

VALUATION RATIOS ARE useful as they help assess both the likely risk of an investment and the expectations the market has about its future. While previous chapters have discussed valuation measures based on earnings, sales and dividends, this chapter discusses book value ratios and how to reach a comprehensive view of valuation based on a broad spectrum of valuation ratios.

Book value

Tangible book value (also referred to as net asset value (NAV)) refers to the company’s assets minus its liabilities. It excludes intangible assets, such as goodwill, brand names, etc.

Book value measure is most suitable for companies that have a great number of high-value assets or an asset-intensive business, such as utilities and telephone companies, where a large amount of infrastructure is required.

Measuring value based on asset value is particularly useful for property companies (property being an illiquid asset class) and financial organisations, such as banks and insurance companies (where most assets and liabilities are constantly valued at market prices).

Net asset value per share (NAV ps)

Net asset value per share (NAV ps) is tangible book value divided by number of shares outstanding. You want to see this figure rising over time, to indicate increasing value. Morningstar provides a history of NAV ps on the ratios segment of its company profile.

Example

Table 9.1 shows the NAV ps for XP Power, which turned positive in 2010 and has risen since then. Over the period, XP Power has been able to increase the value of the company.

Table 9.1 Net asset value per share – XP Power

Price to tangible book value (PTBV)

Price to tangible book value (PTBV) is current share price divided by tangible book value per share. (Tangible book value per share is tangible book value divided by the average number of shares in issue.) This measure looks at the value the market places on the book value of the company. The lower the PTBV ratio, the more likely the company is good value.

Morningstar quotes the PTBV figure in the ratios section of the company profile. A PTBV below 1 means that if the company was sold and the proceeds distributed, shareholders would receive more than the price of their shares. While this is the ideal, companies with a PTBV below 2 also offer good value. Companies with a PTBV above 10 are likely to be expensive and should be avoided.

It is worth noting that PTBV is inappropriate for some companies. Companies that do not have significant assets on the balance sheet (such as service companies and those that rely on intellectual property) are not capital-intensive, which would inflate the PTBV. Similarly, PTBV should not be used for companies that have made a recent acquisition, as this will typically increase book value and lower PTBV because the new assets go on the balance sheet at the full price paid. Therefore PTBV is not a good value measure for these types of companies.

As a general rule, exclude companies that have a PTBV greater than 1.5 times the PTBV of the sector average.

Example

The PTBV for XP Power are shown in table 9.2. At the end of 2017, the PTBV is 12.6. This is above 10, which indicates that the shares are expensive. However, XP Power made an acquisition in 2017, which partially inflated the PTBV. Towards the end of December 2018, the current PTBV fell to 7.8, based on a share price of 2130p.

Table 9.2 Price to tangible book value (PTBV) – XP Power

ROE is a useful companion metric for PTBV. A high ROE normally accompanies a high PTBV ratio because investors naturally bid up the price of a company that gives them a better return on their equity. Likewise, companies that have high earnings growth rates generally have high PTBV ratios, as investors expect the NAV ps to grow. However, a company with a high PTBV ratio and a low ROE indicates that earnings growth may not be translating into shareholder value. This type of company is more at risk of a collapse in its share price.

Combining valuation ratios

Table 9.3 shows a summary of ratios and a general guide on what the numbers mean. Note that the interpretation of these numbers is meant as a rule of thumb rather than a definitive rule; some valuation measures may be inappropriate for a particular company, or an adjustment to the general levels may be needed to account for specific characteristics of a company.

In general, companies with multiple valuation measures that are ‘too good to be true’ or are expensive and classified as ‘poor value’ or ‘avoid’ should be excluded from consideration as these often prove to be bad investments. Reducing the number of bad investments can help you avoid large losses, which has a beneficial effect on portfolio performance.

Table 9.3 Valuation measures

Example

Table 9.4 shows the current valuation scores for XP Power at the end of December 2018. The majority of the indicators suggest that XP Power currently offers good value. The share price has been falling over the second half of 2018. Once the downward price trend reverses, XP Power is likely to offer healthy returns.

Table 9.4 Valuation measures – XP Power

Summary

Book value checks are summarised as follows:

· NAV ps is stable or increasing over time.

· PTBV is less than 10.

Examining multiple valuation ratios provides a general impression of the value a company offers. Avoiding companies that have multiple extreme valuation measures helps to limit losses and improve overall portfolio performance.