Must-know: Price-to-book value ratio shortcomings

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Critical analysis of the price-book value ratio method

Nothing is perfect. Although the price-book value ratio method looks robust, it has a few disadvantages that you should avoid. Many financials have intangible assets on their balance sheets. Remember, we used the tangible book value in the last part. This was done because a company may have assets that contribute to book value but are only accounting entries. This artificially inflates book value. Goodwill from a prior acquisition is an example of an intangible asset which inflates a financial firm’s book value. To correctly reflect a financial firm’s earnings capacity, we deduct such intangible assets, which includes the benefit of using tangible book value. One should keep this in mind when looking at all financial companies. Be it multinational banks like Citi Group (C) and JP Morgan (JPM), traditional banks like Well Fargo (WFC), asset managers like State Street (STT) or other financials that are a part of an ETF like Financial Sel Sect SPDR FD (XLF).

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Accounting standards impact book value

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Are you an investor who invests in foreign securities? If yes, then you may do well by looking at the second shortcoming of using book value. Book value is an accounting value. Accounting standards impact book value. Since accounting standards vary widely across the world, you can’t use book value or price-book value to compare companies across different countries.

Comparing companies across different industries

You should also be careful to not to compare companies across different industries based on a book value multiple, as different industries have different structures. For instance, a real estate company, which is part of an asset-heavy industry, has a very different structure than a technology company. Most of a real estate company’s assets is in the form of land or buildings, and generally the price-book value multiple would be a good indicator of the company’s valuation. But most of a technology company’s assets would be human intellectual capital, which isn’t accounted for in financial statements, and most technology companies trade at high price-book value ratios. So any comparison between these industries would not likely work.

Stock buybacks

Finally, you should keep an eye on stock buybacks. Book value decreases when a company buys back stock. This decrease is to the extent of the amount of buyback. You should always keep this in mind when comparing companies.

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