When and where to use the Price to book value ratio as a valuation?

 My friend in telegram asked me the title question. For him, I derived two answers, hard and easy answers.

Hard Answer

When it comes to valuating a business, there are 2 areas of consideration:

1.       What does the business own?

2.       How much the business does is earning?

However, in this blog sharing, I wouldn’t be sharing on pointer 2. Thus… let’s start with pointer 1.

What does the business own

Assuming there are 3 companies:

1.       Company (A) has Singapore Treasury Bonds (rating: AAA), Investment properties that generate Rental income, and some companies’ shares

2.       Company (B) has quite a lot of stationary inventory and some machinery like photocopy machines and binding machines.

3.       Company (C) has groceries inventory both fresh and non-fresh, for example, fresh fish, meat, vegetable, and canned and frozen food. It also has some machinery to help its employees with their operations, for example, trolleys, meat-slicing machines, etc.

Just looking at these companies and their assets alone, which do you prefer to invest in?

For me, I will prefer to invest in (A). As these assets can sell almost at their face value or even if I don’t sell them, the assets will automatically generate passive income for me.

It isn’t fair to say that (B) and (C) aren’t good businesses. But there are more factors for me to consider determining that. For example, location, how often their inventory turnover is, and how fast, in particular for (C) thanks to their fresh groceries inventory.

If you look in another way, some of the (C)’s assets do not have the luxury of time, and (B) and (C) required me to operate the business to ensure sales and income. While (A) most likely does not require me to be this active.

Thus, if a company has similar assets in its balance sheet like (A). The Price to book value (PB) ratio may be a good idea to use as a gauge.

Usually, when I research the company, I will look at what business it is doing, what assets do its own, how much percentage of its assets is high quality (for example, AAA bonds, investment properties, cash), and how much is book value per share.

So let’s assume that (A)’s book value per share is $100. The asset allocation is 45% AAA bonds, 45% investment properties, and 10% other companies' shares. If the price for (A) share is $50, making the PB ratio 0.5, this might be a good investment opportunity. This gives investors a chance to buy the company for less than what the company paid for those assets.

Of course, there are other factors to consider, but this is a simple example to valuate a business using PB.

In short, the hard answer to my friend’s question is:

Depends on the assets the company owns. The more valuable the asset the company owns, PB seems to make sense.

Easy Answer

So what is the easy answer? In very simple terms, Banks, Insurance companies, and REITs are great usual suspects. As they usually have assets that generate income for the companies.

Banks have loans that generate interest income. Insurance companies usually buy high-quality bonds to earn interest. REITs have properties to earn rental income.

And usually, their allocation for these types of assets is a pretty high percentage in their balance sheet.