The market to book value is quite important. If the stock goes bankrupt, the shareholders might receive most of their investment back or not at all depending on the specific ratio. Furthermore, value investing is based on the concept of high intrinsic value of a stock. The price to value can give one a helping hand when screening stocks with high value compared to its selling price.
Market to Book Value Ratio and Value Stock Screening
A solid stock picking system uses much more than just one simple stock metric such as price to book ratios. Investors trying to pick the best stocks with screening tools should consider more criteria such as the value and growth hybrid screening found here.
First, what is book value? The book value of a company is the ‘net asset value.’ This is calculated by adding together the assets and subtracting the intangible assets and liabilities. In theory, the book value is what the company is worth should the operation cease to function and the equity be divided among shareholders.
- Suppose a stock has 200 million dollars in assets and 100 million in liabilities. The book value is 100 million.
- The market value is simply the price that the stock is trading at. If the company has 100 million shares and the stock is selling for $2 per share, the market value of the company is 200 million dollars.
- Market to book value ratio is simply a comparison of the market price to the intrinsic value of the stock. In the above example the market value is $2 per share while the book value is $1 per share. Therefore the market to book value is 2.
If the market to book value is 1 this means that the trading value is equivalent to the net asset value. In theory the price of the stock should not go less than this, but it definitely can as will be discussed next.
Warnings of Market to Book Values
Many investors assume that if the market to book value is 1 or less, than this is a very safe undervalued stock pick. This assumption is faulty. Consider some of the scenarios that can create low market to book values:
- The company just lost some massive contracts stifling future growth
- The assets are depreciating quicker than what is being written off
- The economy is bad and the assets would sell for less what is on the accounting ledger
- Liens exist against the assets that are latent
Also to be considered is that some very profitable companies with few assets will have higher price to book values than businesses with a lot of real estate or machinery. IT companies and other service based businesses may be overlooked simply because their price to book value ratio is high due to lack of assets.
How Market to Book Value Can Help Investing
Some investors that are looking for value will screen out stocks with a market to book value over 2. This means that if the selling price of the stock is more than double the net asset value, the investor will pass this stock by.
Book value is not the final word in value investing, but it still deserves a worthy mention. Book value can create a type of support for a stock if a bear market attacks or if the stock falls out of favor. Prices can go lower than book value but it provides a ‘safety net.’ Even though low market to book value does not provide total insurance against a loss, it will likely fare better in tough markets than a price to book value ratio that is multiple times higher.
The market to book value ratio is a staple part of stock scanning for value investing in volatile markets.