Monday, April 20, 2009

Price To Book - When EPS fails and you consider liquidation

Price to Book value is often quoted as an appropriate metric when EPS is not applicable but when does it apply? First, looking at the underlying logic of this solvency ratio:

P/B = Market price of all equity / Accounting Book value of company

Although there are generally two stages where negative EPS is characteristic (pre-mature growth and precipitous decline) I think the most appropriate use of this ratio is in liquidation (pre-decline). If negative EPS (or even negative operations income, NOI, manifested as negative operations cashflow versus positive invement and financing cash flow) is a result of growth, P/B will dramatically undervalue the ability of management and growth potential. A start up company will be dumping cash investments and financing in the hopes of future revenue.

I would propose that P/B is generally only useful as a ratio under very specific circumstances, particularly for use as a liquidation decision metric. For example, with a P/B of approximately 1, it would assume (that given perfect liquidity of remaining shareholder's equity) that for the cost for cutting up the company is approximately the same as it's acquiring price.

Therefore a P/B more than 1 means the company is overvalued compared to it's assets. This translates as either it is headed for decline (shorting opportunity) or investors think a turn around is possible with the difference reflecting "management value added" and potential growth of assets as is similar to any growing company.

This is the case that I would make to imply the P/B is a relatively useless decision metric for general investing, yet at the same time the only one that makes sense in the relatively narrow valuation space of liquidation.

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