Well ... with regard to the ratio of Price to Book , let me give you my opinion and assessment, with particular emphasis on "Book Value".
Briefly, we have the Balance Sheet equation which says :-
Share Capital + Reserves + L.T.Debt + Deferred Tax = Fixed Assets + Current Assets - Current Liabilities, i.e.
Capital Employed = Employment of Capital.
For the purposes of the exercise, let’s consider a company with no L.T.Debt and nothing set aside for Deferred Tax. Hence we have,
Share Cap. + Reserves = F.A. + C.A. – C.L. ...(A)
Now, even though C.A. and C.L. will change month to month, their amounts as shown in the Balance Sheet are a Cost as of a particular date. A sort of "current Book Value". More importantly, in my opinion, is the amount for Fixed Assets which is the ORIGINAL Purchase Price of the items contained, and which is, more often than not, the largest number on the right hand side of equation (A). By their very nature, Fixed Assets are in at Book Value. That original monetary amount cannot be increased by a possible increase in asset value. Therefore, as I’m sure you’re aware, the right hand side of (A) indicates the magnitude of the Book Value of the company’s Net Assets. Therefore, because things must "balance", we have ...
Share Capital + Reserves = "Book Value of Company’s Net Assets".
So if one divides "Share Capital + Reserves" by the number of ordinary shares in issue, we get Book Value per share (bearing in mind we’ve ignored L.T.Debt and Def. Tax).
Sorry if I’ve gone through stuff which you are probably well aware of, but I wanted to arrive at the denominator of the Price/Book ratio, in order to discuss my opinion regarding its relevance.
If we now consider a company whose Share Capital remains constant for a long period of time, the only VARIABLE, apart from "Price" in the P/BK, is "Reserves". But where do "Reserves" come from ... from the algebraic addition, OVER TIME, of the Bottom Line of the Income Statement. And the concept, OVER TIME, means that Profits could have been added, or LOSSES subtracted. Logically speaking, it infers that the number in "Reserves" was influenced by past events which may not necessarily reflect the current state and "business plan" of the company.
In addition, I was considering a company with ‘constant’ Share Capital. But this may not always be the case. A company may need to increase its Share Capital for several reasons. One reason could be that, because of ongoing Losses, it may be heading towards Insolvency because Total Liabilities are nearly exceeding Total Assets. We come back to equation (A) which can also be written ...
Share Cap. + Reserves = Total Assets – Total Liabilities.
Therefore, increasing Share Capital will obviously affect the denominator of P/BK, for the wrong reasons, i.e. the company ain’t doing too well !
However, there is another ratio which contains Price and whose denominator is much more current and reflects the latest state of affairs with regard to the Bottom Line. After all, that’s where it comes from ! I, personally, prefer to use the P/E ratio, and regard it as most relevant when calculated within a short period AFTER a company presents its latest set of Financial Results.
In your previous reply, you referred me to a link of Tweedy Browne, presumably, because of the work they had done regarding company performance as related to P/BK. Well, not knowing the details of their research data etc.., I obviously can’t comment. However, when visiting their site I had a look at the performance of one of the two Funds they advertised, viz. American Value Fund. Here we have a company of supposed "experts" who can only manage to beat the performance of the S&P 500 Index in 4 out of 13 years ! They are currently performing nearly twice as badly as the S&P 500. Their 10 year annualized return, after taxes, was only 9.88%. Hardly anything to write home about !
Needless to say, this is not unusual in the world of Fund Managers. In my part of the world I could have made over 40% capital gain over the last 12 months by buying Index shares. I’d have to look long and hard to find local Fund Managers who would have given one that return AFTER deducting their "Management Fees" !
It wouldn't surprise me if the same holds true in other parts of the world. |
