Wednesday, May 31, 2006

Price to book

This post is updated in 2023.

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.

To use another analogy, say some bloke is selling you his 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 bloke this but he is still grateful that you bought the car at $5,000 anyway. Translating back to finance lingo, you just bought something for 0.5x PBR and made 100% profit. 

By left, stocks trade below book value for as many reasons as why your wife / husband refuses to let you meet your buddies / girlfriends for a drink-all-u-can / let-your-hair-down night out, 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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