By Shawn Allen, Contributing Editor

In value investing, a low price to book value (p/b) ratio is generally considered to indicate a potential bargain. But it may simply signify a poor business and a value trap. The most profitable companies always have a high p/b but may not be overpriced.

Book value refers to the balance sheet value of owner’s equity. And owner’s equity is the cash that a company has raised from its owners by selling shares plus its accumulated retained earnings. So, book value represents the total investment that a company is holding on behalf of its investors.

The price to book value ratio can be very difficult to interpret and indeed at times provides little to no guidance. There is no one level of the p/b ratio that would work across different industries and companies. Some industries, by nature, tend to trade at relatively modest p/b ratios. Some examples:

• Banks can only leverage their equity to a certain maximum amount by regulation. This tends to limit the level of their p/b ratios.
• REITs in Canada mark their properties to book value each quarter. Therefore, it would be very unusual for a REIT to trade at more than a modest premium to book value.
• Regulated electricity and gas utilities typically receive a prescribed return on their book equity invested in regulated assets. Therefore, it is logical that they trade at only a relatively modest premium to book value.

Meanwhile, some companies can trade at many times book value without being overvalued. This includes companies that face limited competition due to powerful brands or that enjoy quasi-monopoly power.

Price to Book Value as a Performance Metric

Warren Buffett indicates that Berkshire Hathaway should only retain earnings as long as the price to book value is above 1.0. Specifically, his test for Berkshire over each five-year period is: “(1) during the period did our book value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense.”

Based on Warren Buffett’s principle, any company that consistently trades at a p/b ratio of less than 1.0 over a period of years is failing investors. Such a company should pay out any earnings to the extent it can rather than retain them. To retain them is effectively turning dollars into something less.

Companies that earn attractive returns on equity tend to trade at a p/b ratio above 1.0. Just like a bond that is paying above the going rate of interest will trade at a premium to par value, a company that is earning more than the market required return on equity will logically tend to trade above its book value.

Consider that Costco trades at about 11 times book value and Visa at about 14 times. These ratios are a testament to their exceptionally high returns on equity and fantastic business models. They do not necessarily indicate overvaluation.

A company that is trading at a price to book value ratio of 10 has turned each dollar of investor capital and retained earnings into ten dollars of market value.

In contrast, a company that is trading at a p/b ratio of 0.75 has turned each dollar of its owner’s equity into 75 cents. If such a low ratio persists over a few years this is indicative of a company with poor economics and likely poor management. Unless there is good reason to expect a turn-around, investors may be wise to avoid these companies even though they may look like bargains.

Conclusion

The p/b ratio should be looked at but must be interpreted with caution. A low ratio sometimes signals a bargain, but it can also simply reflect a poor business, which would be a value trap. On the other hand, a seemingly stratospheric p/b ratio often reflects a high-quality and high-profit company. In each of my updates below I indicate how I would interpret the ratio for each of the updated companies.

Contributing editor Shawn Allen provides stock picks and investment education on his website at www.investorsfriend.com. He is based in Edmonton.