The trouble with the P/B ratio

Fsp Invest, 07 Oct. 2013

Tags: p/b ratio, price to book ratio, problem with the p/b ratio, balance sheet, company’s brand, what are the drawbacks of using the p/b ratio

The price to book (P/B) ratio is a great tool to look at the value of a company. This is especially so if the company is asset intensive, such as a property company or an investment trust. But there is one major problem with the P/B ratio. Read on to find out the trouble with the P/B ratio…

There is one general problem with the P/B ratio, Tim Bennett in MoneyWeek explains…

The balance sheet is the basis of the data used in the ratio. But balance sheets are only a snapshot of the company on a given date. So the figures may well have changed, sometimes quite dramatically.

This means the P/B compares apples and oranges to an extent. It uses the current share price, which is right up to date, with the balance sheet, where the information is slightly older.

But the main problem is that the ratio’s accuracy relies heavily on the ‘book’ value for the firm being meaningful, i.e. not too far from a realistic market valuation for the firm.

That’s why it works best in asset-intensive sectors, where it’s easier to agree on a concrete value for an asset, and not so well in service-driven sectors.

The P/B ratio ignores the worth of a company’s brand

For example, it starts to fall down when you look at a firm such as Apple.

Apple’s P/B ratio comes in at more than 6. Yet plenty of investors would still think about buying it even though on a P/B basis it’s a total rip-off. What’s going on?

The trouble with using P/B to value Apple is that there are certain key assets missing from the balance sheet. The value of the firm’s brand is the biggest.

Since accountants only like to include things in a balance sheet that can be reliably measured, intangible assets such as reputation, staff quality and market share get left out, even although any buyer would clearly factor them in to a valuation of the firm.

This can leave the ‘book’ a bit light and lead to artificially high P/B ratios.

So there you have it, the trouble with the P/B ratio.

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