How to determine if a company is worth more than its current market price

With just a few short weeks left to the end of the year, there has been an interesting vicissitude of activities within the Nigerian Stock Market. Its concomitant bull and bear run have, in multifarious ways, mirrored economic and fiscal activities in the country, and of course, across the globe.

Some of these activities have resulted in positive financial results by some companies listed on the NGX as it has also adversely affected others, all leading to a tempting index return of +15% earlier in the year before it’s unfortunate, but understandable easing hitherto.

Of more curious interest is the fact that some of these equities have, in many ways, rebelled against market forces and remained relatively cheap, price-wise, compared to their released financial results, particularly for Q3.

It, therefore, goes without saying that a deep ocean of opportunity to fish from for relatively cheap company stocks currently exists within the market. But what do we buy and why? It can be hard to tell without the proper tools guiding us. Thus, for the next few weeks till the year’s end, more particularly, until financial full-year results are announced, we will brush up on our financial ratios, understanding their importance, and when and how to use them.

We shall begin with the popular and extremely critical Price Book Value (PBV) analysis, used by many financial analysts.

So, some of the greatest stock market investors of our time, such as Warren Buffett are proponents of what is known as “value investing” and there is no fundamental analytic metric more associated with company value than the Price to Book ratio.

Simply put, the price-to-book ratio, or ‘P/B ratio’ or PBV, is a financial accounting and analytic ratio used to compare a company’s current stock market price, to its book value. The ‘book value is the value of a company’s assets expressed on the balance sheet compared to its liabilities.

The idea behind value investing is to find what is termed ‘market sleepers’. These are companies that should be worth more than are at current market price, at a given period. Value investors search for and hold them whilst others are oblivious to their true worth and then sell them at a great profit when they finally make the news and the stock price is driven upwards by a sudden demand.

However, it is important to note that the PBV, critical as it is, has its limitations and under some circumstances, may not be the most effective metric for valuing companies, and we will soon see why.

Regardless, companies with a high PBV, typically greater than Numeral 1 (one), sometimes written in analytical terms as ≥1.0x, are deemed overvalued, whilst companies typically with representations less than 1 (one), written as ≤1.0x, are considered undervalued and worthy buys.

But how do we come about these values you may ask? Well, dependent on the balance sheet and the sector, the computations are typically not very difficult, particularly if you have a pen, paper and a calculator, or better still, know-how of MS Excel.

Another important notice, as with most ratios, however, there is a fair amount of PBV variation by industry. Certain Industries which require huge infrastructure to drive profits will typically trade at PBVs much lower than, for instance, IT or consulting firms.

Thus, PBVs are commonly used to compare banks and other financial institutions against each other, as most assets and liabilities of such institutions are constantly valued at going market rates.

It is also worthy of note that PBV analysis does not directly provide any information on a company’s ability to generate profits or cash for shareholders. It just provides information on a company’s going market value, compared to its price at a given period and its balance sheet information within the given time.

So, it is critical that if you must ever use a PBV analysis to make a decision, all information needed should be culled from a given financial window, not before or after.

One rather easy way of calculating the PBV can be done in three steps from viewing a company’s financial statement. Firstly calculate what is known as the ‘book value’; Subtract the company’s total liabilities from its assets. Next, you divide the book value by the company’s outstanding shares to give you its ‘Book Value Per Share. And finally, you divide the resultant Book Value Per Share by its last traded Stock Market Price to give the ‘Price to Book Value.

Represented thus:

Step 1: Assets – Liabilities= Book Value

Step 2: Book Value ÷ Total Outstanding Shares= Book Value Per Share

Step 3: Last Traded Share Price ÷ Book Value Per Share= Price To Book Value (PBV)

Example

Let’s calculate the PBV of Bank XYZ which has reported the following in its latest financial statement:

Total Assets: N120Billion. Total Liabilities: N84.2Billion. Total Outstanding Shares: 9Billion Units. Latest Share Price: N1.67k.

Using the above graphical representation;

• Book Value – N120Billion – N84.2Billion = N35.8Billion
• Book Value Per Share – N35.8Billion ÷ 9Billion Units = N3.98
• Price to Book Value – N1.67k ÷ N3.98 = 0.4195 (Ξ) 0.42 (Ξ) 0.4

As can be seen, the final result offers a valuation often written as 0.4x which when compared to 1.0x, shows that Bank XYZ is 0.6x times cheaper than it seems, comparing its Book Value to its latest traded share price. In other words, the company is 60% cheaper in market price than actually should be. Thus, the share price, at its current Book Value, should be in the region of N1.67k * 60% = N2.672k (Ξ) N2.67k or approximately N2.70k, give or take.

Thus, at the current share price and book value, Bank XYZ would typically be issued a BUY rating. However, remember that other matrices often intertwine before such ratings can be offered. So, do not rely solely on the PBV valuation when making your decisions, but always keep it in mind, and compare equities within sectors.

Another quick and nifty way to calculate the PBV would be to divide the Bank’s latest Market Capitalization by its going Book Value;

Market Capitalization – Latest Traded Share Price (N1.67k) x Total Outstanding Shares (9Billion Units) = N15.03Billion

• Book Value – N120Billion (Assets) – N84.2Billion (Liabilities) = N35.8Billion.
• Thus, PBV = N15.03Billion ÷ N35.8Billion (Ξ) 0.4x, arriving at the same figure as before.

Another quick example would be of insurance company ABC which reported the following figures for its Q1 financial period.

Total Assets: N15.7Billion. Total Liabilities: N12.3Billion. Total Outstanding Shares: 9 billion units. Latest Closing Share Price: N0.90k

Calculating its PBV thus;

• Market Cap – N0.90k x 9Billion shares = N8.1Billion
• Book Value – N15.7Billion – N12.3Billion = N3.4Billion 
•  PBV – N8.1Billion ÷ N3.4Billion = 2.382

Thus, at approximately 2.4x, Insurance Company ABC could be deemed over 240% more expensive in market value than should be, and should thus be trading at a price closer to 0.90 ÷ 240% = N0.375k, or N0.40k, perhaps lower!

As can be seen, the assets and liabilities column of any financial statement is a vital component of a financial report and should be taken seriously when analyzing a stock.

With that said, some drawbacks of using the PBV to make investment decisions include:

Accounting Standards: When accounting standards vary by country or sector, PBV may not be comparable. Thus, should you find yourself wishing to invest in a company say in another sector or abroad, it is best to first understand what sort of accounting standards are applicable before employing PBV in relation to other companies within its sector.

Companies in Distress: The PBV also gives some idea of whether or not you may be buying into a company at too high a price, however, for companies in financial distress; the book value typically has to be calculated without the company’s intangible assets that would have little or no resale value. In such cases, the PBV is often calculated on a “diluted” basis, which can be tricky for even the most vested financial expert.

Capital Intensity: If most of a business’s assets are intangible, as is the case with many IT companies which deal mostly with proprietary licenses, a PBV metric may be unhelpfully high about 1.0x making the company seem an unattractive investment when it ironically actually is, which is why the PBV should be mostly used for capital-intensive businesses like financial institutions, manufacturing firms, etc., with tangible asset intensive balance sheets.

One-sided Picture: A PBV valuation, particularly a low one, can be deceptive if used on its own to analyze the possible investment in a company. It might never tell the entire story about the company’s true status. More reason it must never be used as a standalone metric but in conjunction with other matrices to get a more holistic picture of a company’s true market value vis–a–vis its price.

Period Specific: True, a PBV below 1.0x does ofttimes point towards undervalue as does the other way around. However, this metric is not a lifelong rubber stamp of undervaluation or otherwise, reason why you will have to perform this calculation as frequently as the price of the equity continues to fluctuate, and against the backdrop of its most recently released financial report, never before or after as the results could point you in the wrong financial direction.

More in the series to come…