5.9 Price to Book Ratio

 

Price/Book Ratio is a measure of the  number of
years to recover the stock price with zero growth in book value per share.

The book value per share is a measure of the capital that shareholders have invested in the company.  It is defined as the shareholder’s equity divided by the number of shares outstanding.  An important bottom line driver of the price to book ratio is the Return on Equity (ROE), which relates net income to shareholder capital. In the next example we first examine this relationship for a small set of firms.  In this example, the highest recent ROE is IBM and the lowest is Target.

Example:  Stocks Price/Book Value versus ROE

 

Interpretation of Above Example

A high Price/Book Ratio implies that investors expect management to create more value from the set of resources under their control.  In addition, a high Price/Book Ratio can also reflect accounting measurement issues.  For example, you can see above that IBM is the highest and Target is the lowest in the above sample.  This in part reflects the relative importance of labor in terms generating revenue.  For the case of IBM it heavily relies upon highly skilled human capital to provide solutions to IBM’s clients.  The retailers Wal-Mart and Target rely more heavily on their product offerings in super and regular centers to generate revenue.  Further because human capital is not capitalized under US GAAP the relative importance of labor will be reflected in the Price to Book ratio.  The table shows that there is a clear relationship between Price to Book Value and ROE in at any point in time, a higher Price to Book Value is associated with a higher ROE.

If you look at KO and PEP in the table, for the TTM, the Price to Book Ratio is a little higher for KO than it is for PEP (4.69 vs. 4.53.  In recent years, though, PEP has been higher than KO.  The current reversal could imply that the market is expecting KO management to generate more value from the existing set of assets than is the case for PEP, perhaps if the acquisition of bottling plants leads to increased sales resulting from the increased marketing flexibility and resulting in a higher ROE.