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Of course, the topic of valuation is always subjective. Any one ratio by itself is unlikely to constantly lead to correct valuation decisions. For a range of other different valuation techniques, why not pop across to our Fool's School on How to Value Shares?
But there is one valuation measure that has certainly had its day. It's the result of dividing any company's market capitalisation by its book (or net asset) value. It's commonly referred to as the "Price to Book" (P/BV) ratio. Traditionally, a P/BV under 1 is considered "good value".
The underlying concept for the ratio is simple. If you've found a company that is selling for £100m, and it has assets of £200m sitting in its accounts, then isn't it obvious that the company is good value? The basis of the strategy is that every other investor will sooner or later recognise this discrepancy and eventually the company's market value must reflect the value of the assets. I mean, if they didn't, surely a corporate predator could step in and buy the company for £150m, and get the £200m of assets at a 25% discount.
The Dark Ages
Back in the dark ages of investment, before calculators and computers were all-pervasive, this approach to investing was quite common. In fact, the so-called "Father of Investment" and mentor to legendary investor Warren Buffett, Ben Graham, used this P/BV philosophy to great effect many years ago.
In his book, the epic Intelligent Investor, Graham describes his method of buying companies valued at two-thirds of their working capital assets. Of course, in the days when the leading investment tool was an abacus, this sort of undervalued company was ten-a-penny. Back then, it took a very dedicated investor to get hold of all the necessary information and make the calculations themselves.
These days, every possible valuation ratio is presented to all and sundry through computer terminals. And thus, with the information far more widespread, so the stock market becomes far more "efficient". Graham's bargains of yesteryear gradually disappeared and so his winning strategy eventually petered out. Buffett tried the strategy for a while too, but quickly gave up to look for more suitable investment criteria.
What made Graham's approach viable was the type of company assets against which he measured the market valuation -- the company's working capital. These assets, comprising of stock, debtors, creditors and most importantly cash, all had a short-term realisable value. The stock could be sold, the debtors could be called up and, well, cash is cash. There is slightly more certainty about the "cash value" of these assets than other items on the balance sheet.
The perils of fixed assets
Graham's working capital bargains are long gone. Today, it is fixed assets that lure unwary investors into P/BV trap. There are still plenty of companies that have P/BV ratios under 1, but there are many reasons to be cautious about a supposedly low P/BV.
Although all assets are an accountant's best guess, fixed assets are perhaps more susceptible to a book-keeper's optimism than most. Using subjective depreciation policies from the historical cost of the asset understandably leaves a lot of leeway. The true value of what any asset is worth is what a buyer is prepared to pay for it. Anyone who has tried to sell a second-hand car should know this basic fact of investment.
Having ploughed through the annual report of troubled food retailer Somerfield (LSE: SOF), a company that has a current P/BV of 0.6, Gilesby came to this conclusion:
"Looking at the results, it is not hard to see why the Kwik Save stores (can be) deemed valueless... The NAV (net asset value) in the accounts is nowhere near correct, and certainly does not reflect any easy sale value."
Notable other companies that have brought much distress to "value" investors are RJB Mining (LSE: RJB), Arcadia (LSE: AG.) and Storehouse (LSE: SHS), with P/BV ratios of 0.32, 0.33 and 0.69 respectively.
Loss-makers
The common trait of the four companies mentioned above, and most other low P/BV companies, is that their assets are unprofitable. They lose money hand over fist. And if they can't make any money from the assets, then the "true" asset value will never be realised. Who wants to buy something that can't be seen to turn a profit?
The very fact that the assets of RJB, Somerfield and so on are loss-makers, and that nobody has quickly stepped in to snap up these apparent company "bargains", leads me to believe that their assets are actually not assets at all. Instead, they are corporate liabilities.
If these persistent loss-making "assets" can be declared by accountants as liabilities, then perhaps the P/BV could have some merit. But until that day arrives, the P/BV ratio warrants very little investment attention.
The Fool's Eye View is published four times a day, at 10am, 12 noon, 2.45pm and 5pm.
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