Wednesday, May 31, 2006

Price to book

Besides the price earnings ratio, another widely use valuation metric is the price to book ratio, or PBR. This is simply price of the stock divided by its book value per share.

The book value of a stock is also called its shareholders' equity which is whatever that is left for shareholders after all its assets are sold and all its liabilities are paid off (shareholders' equity = assets - liabilities)

By right, a stock should never trade below its book value, because this means that we should sell everything the co. has, pay all its debt and distribute what is left back to shareholders, which is more than the stock price on the market. So theoretically, one can arbitrage when a stock trades below its book value.

Now if you don't get the above, it is saying that some dumb babe is selling you her car for $5,000, but if you take out the tires, the engine, the stereo and all other parts and sell them separately, you get back $10,000. You tell the babe this but she is still grateful that you bought her car at $5,000 anyway.

By left, stocks trade below book value for as many reasons as why your wife refuses to let you meet your buddies for coffee, and as Warren Buffett learned, buying each and every stock below book value does not guarantee good return.

See Price Earnings Ratio

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