Course 305: Price/Book and Price/Sales Ratios
Price/Book Ratio
In this course
1 Introduction
2 Price/Book Ratio
3 Price/Sales Ratio

Many investors use price/book because they believe that earnings are more variable and subject to accounting shenanigans than book value is. Book value is what would be left over for shareholders if a company shut down its operations, paid off all of its creditors, collected from all of its debtors, and liquidated itself. It's a more tangible measure of value than earnings, because book value tells you what you might actually get paid for a company in cold, hard cash. Even though book value is theoretically what shareholders would receive if the company were liquidated, this is rarely the case in practice. That's because the value of assets and liabilities can change substantially from when they are first recorded. For example, a railroad company that paid a few dollars for an acre of land out west 100 years ago would have a far more valuable property today. That acre of land, however, continues to sit on the company's balance sheet at the original purchase price. It's important to think about a company's basic characteristics when you're looking at its P/B ratio. A good proportion of a manufacturing company's worth is tied up in inventory and machinery, which are relatively well reflected in its book value. A software company like Oracle ORCL, on the other hand, has a lot of its worth tied up in intangible assets like patents, market share, and the talents of its programmers. Since intangible assets such as these aren't taken into account when book value is calculated, Oracle's book value isn't as good a measure of what shareholders would receive if the company were liquidated. It's also important to keep a company's return on equity (ROE) in mind when looking at its book value. If a company can make high returns on its book value, a high P/B is probably no cause for alarm. For these companies, the "B" is simply more valuable, because the firm can use the book value more efficiently to generate profits. For example, the relationship between Microsoft's P/B and ROE is a telling measure of its operating efficiency. Microsoft commanded a P/B of 17 at the end of 1999 because it continually earns returns on shareholder equity of 25% or more--something that relatively few companies are able to do.

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