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Wednesday, September 12, 2007

Price to book value ratio

Price to book valueratio is one of the basic valuation ratios,one which u may hear most often after the P/E ratio.However,this ratio is not very useful in many cases,particularly at these time in the bull market.

In terms of defination it is share price divided by book value per share.The book value per share is net worth divided by number of shares.Often,analyst adjust net worth by removing revaluation reserves.However,not many companies have revaluation reserves,so if u dont bother about revaluation reserves,thats fine in most cases.

The problem about book value is:Its not of muh help when its greater than 1.Currently,in the BSE 500 list,i guess only 20-25 companines hav price to book value ratio of less than 1.So 95% of the companies are quoting above book value.When companies are quoting above book value,its dificult to say whether they are cheap or exopensive on the basis of only this ratio.For example,HLL has a book value of 12.5 at curent prices.Even at its low of rs 100 2 years ago,its book value was around 7 or so.Clearly a book value of 7 didint deter the scrip from more than doubling.This is coz,in HLL"S case and in many other busineses,book value wil always be significantly greater than 1.

Many FMCG comopanies like HLL have been working with negative working capital.They also dont have much of fixed assets.Therefore,these companies can build sizeable businesses without having to keep toomuch capiatl in the business.In other words thy dont nd to retain too much of the profits to grow.Same is the case with IT companies.Infy has a price to book of 9 times.IT companies also arent too capital intensive.Other than investing in office buildings,they dont nd much capital.Here again price to book value ratio has litle meaning.

Ths ratio has some meaning only when it is less than one,then it means either of two things-Either the company is undervalued or the company is in a declining business.Take the case of MTNL.It has a price to book of 80%.This company has been loosing customers for the last few years to private telecom players.Its sales and profits are declining.Or take companies like ITI.These companies have eroded their networth and hav a negative book value.So most companies quoting below book value are companies with declining businesses and with no great future.These are companies no one wants to own.If for example,MTNL gets its act together,there may be great upside in the stock.

Price to book value has meaning for the banking sector.This is becos here,the book value or net worth is akey factor which determines growth.A bank nds to maintain a minimium capital adequacy ratio,which acts as a cap to growth.This is 1 reason why bank sud not quote significantly baove the book value.Quite a few banks have book value less than 1:example being Bank of maharastra,south india bank.Some of these cud be worth looking at.

Sometimes,companies quote below book value if their accounts are not genuine.Some compamnies show bogus profits,which means that the networth shown is not correct.Sometimes,companies have high levl of debtors and loans and advances,some of which are not l;ikely to be repaid.If such companies dont take a rite-off,then again networth wont b genuine.In the current list of companies uoting below book value,there are some companies which may fall in this category


Regards,
ARUN

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