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In investing, the book value of equity is a significant metric. It is a simple calculation - total assets minus total liabilities, and represents a company's net worth. The book value of equity plays a crucial role in various aspects of investment, from solvency to valuation, but can we blindly trust these book values? The answer is NO!
The price-to-book ratio fallacy
Investors usually consider companies trading at less than book value as undervalued. However, this valuation isn't always reliable because the price-to-book ratio depends on the basis of measuring assets and liabilities.
The P/B ratio is a reliable indicator, if assets and liabilities are measured at fair value. So, the financial industry is one of the only industries where P/B would be an appropriate measure. It includes banks, NBFCs, and insurance companies. Since a significant portion of their assets are financial instruments and advances, companies usually record them at fair value, making book value a reliable measure most of the time.
On the other hand, in sectors where assets and liabilities are measured at historical cost (the price that the company paid at the time of purchase), P/B may not be very useful. It is not just for non-current assets such as plants and machinery but also for current assets. Trade receivables may not all be collectable, and inventories may not have the same market value. An example is Parag Milk Foods .
In FY21, the company's inventories formed a significant part of its assets. However, the balance sheet changed dramatically in FY22 when the company wrote off inventories. Book value fell, debt to equity ratio increased, and P/B shot up.
Case 1: Parag Milk Foods
An inventory write-off alters the P/B ratio
| Particulars | FY21 | FY22 |
|---|---|---|
| Inventory (Rs cr) | 695 | 475 |
| Total assets (Rs cr) | 1,683 | 1,395 |
| % of total assets | 41.3 | 34.1 |
| Debt (Rs cr) | 384 | 523 |
| Equity | 928 | 551 |
| Debt to equity (times) | 0.41 | 0.95 |
| P/B ratio | 0.96 | 1.66 |
| P/B as on last day of financial year | ||
Furthermore, if goodwill forms a big part of the assets, P/B is not a reliable indicator. It can easily inflate the book value even though it might not deliver any monetary value, thus resulting in a lower P/B. A good example is Rain Industries , which had a significant level of goodwill in its asset book, distorting the P/B value.
Case 2: Rain Industries
Goodwill distorts the P/B ratio
| FY22 financials | With goodwill | Without goodwill |
|---|---|---|
| Total assets (Rs cr) | 21,945 | 15,047 |
| Debt (Rs cr) | 9,731 | 9,731 |
| Book value (Rs cr) | 8,427 | 1,529 |
| Debt to equity (times) | 1.15 | 6.36 |
| Market cap (Rs cr) | 5,583 | 5,583 |
| P/B ratio | 0.66 | 3.65 |
| P/B as on last day of financial year | ||
Industries where P/B is less appropriate
Technology or service-based businesses - In businesses such as consulting firms or advertising agencies, intangible assets like human capital, patents, intellectual property, and innovation often account for a significant portion of the company's value. These assets are difficult to quantify on the balance sheet, making the P/B ratio less relevant for valuation.
Manufacturing companies - Manufacturing companies typically record their non-current assets at historical costs. As a result, it isn't easy to assess the fair value of those assets, making P/B a less effective measure.
In summary
It is essential to understand the business's nature and the assets' composition on the balance sheet before using the P/B ratio. As shown earlier, the book value can be susceptible to distortion.
Also read: The power and pitfalls of operating leverage
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