An easy way we can estimate the valuation of a company is to look at its price-to-book value.
The worth of a stock is its current value of the future cash it generates. We can view this cash in terms of the dividends paid out or how much cash the company generates.
While this is not a perfect theory, it does give us the structure we need to compare different companies no matter how they handle their cash. The only problem with this is, giving a stock analyst the task of doing this comparison will wind up producing a very long and complicated spreadsheet for us to decipher.
Wouldn’t it make sense, if a company’s worth is the current value of its future cash flow, to calculate the cash flow, discount them to their current value and then get a total? Well, that is what we call a “discounted cash flow” calculation. It’s a very popular tool used by analysts, but it can be a long and complicated process.
Numbers running wild
Doing a “discounted cash flow” calculation will produce a very nice looking spreadsheet, however in creating the spreadsheet it is easy to get caught up in doing calculations and forget about the numbers you entered. Then, when the estimates are combined, the results we get are rough estimates that don’t help us very much. I know if I put all of that work into something, I may also give more credibility to the finished product than it deserves.
Luckily, we have a few simpler valuation tools that we can use. Those tools include, ‘price-to-book’, dividend yield and PER (allowing for a large margin of safety). It is important for us to recognise, however, that even these tools will only help us reach an estimate of the current value of a company’s cash flows.
Of the three tools I mentioned above, the simplest one is the price-to-book ratio. This is a company’s market capitalisation divided by its net asset value (also known as book value). Book value tells us how much the company has paid for all it owns and what profit they would receive if they were to sell everything and return the proceeds to their investors.
The beauty of book value is its simplicity, but it does have some problems. Book value shows what a company paid for its assets minus some random charge for wear and tear and some confusion on the accounting end. What it doesn’t show us is the value of the company’s assets.
This means that we need to be cautious when we include assets in our book value and the values we give them. Companies in a declining industry may have a balance sheet that does not accurately reflect their lower value. Cash on the other hand, has a more defined value. Then we have things such as inventory and debtors. Their value is dependant upon whether you feel confident that they can successfully be turned into cash.
There may also turn out to be some assets, property being one of them, that are understated. “Intangible”, yet valuable assets such as intellectual property, brands and goodwill may not show up.
So, now we have come full circle and right back to the basic truth that capital’s worth is its earning capacity.
Not all capital is the same
Our next problem with book value lies in the fact that one company’s returns to not equal another’s. Whether it is because of good management, competitive advantages or a combination of both, there are just some companies that have returns that are consistently above average. In theory, economics say that these variables will work themselves out eventually, but in reality, they can continue on indefinitely.
Simply stated, a strong business commanding high returns will provide a justification for a higher price-to-book ratio while a poorly performing company with low returns will be much lower. Just look at the Price to Book of Johnson and Johnson (JNJ), which has almost always traded well above book value.
In a nutshell, the pros of price to book are that it is fast and simple. The cons are that it will not give us much information about the true value of a company. Either way, it can be a useful guide if used as a quick rough guide only.