P/B ratio

In honor of Warren Buffett’s latest acquisition, I wanted to explain one of his favorite valuation methods: evaluating a company’s price-to-book (P/B) ratio. Broadly speaking, the P/B ratio compares a stock’s market value to its book value to determine whether or not the company is undervalued.

Book value is a company’s assets (cash, inventory, equipment, real estate, etc) minus intangible assets (copyrights, logos, etc) and liabilities (debt, unearned revenue, etc.).

Consider a simple example in which a company has $100 million in assets on the balance sheet and $75 million in liabilities. If there are 10 million shares outstanding, each share would represent $2.50 of book value. If each share sells on the market at $5, then P/B ratio would be 2.

A company may be trading at less than its book value (or have a P/B ratio of 1) for two very different reasons. One reason could be that the market believes the asset value is overvalued or that there is something fundamentally wrong with the company. If this is true, then investors should stay away since a downward correction of that asset value by the market would result in negative returns.

The other possibility is that the company is earning a dismal (maybe even negative) return on its assets. In this case, changes in management or business conditions may prompt a turnaround in prospects and provide strong positive returns. If this turnaround never materializes, then the company could at least be broken up for its asset value and, in turn, provide shareholders with a profit.

Although the P/B ratio is traditionally used by value investors, it’s also useful for investors seeking growth at a reasonable price. Growth companies tend to have higher P/B ratios, which is fine as long as the company has a high return on equity (ROE). Large discrepancies between P/B and ROE should raise a red flag.

So how does Buffett’s recent acquisition of Burlington Northern Santa Fe (BNI) railroad look?

The purchase price of $100 a share gives BNI a P/B of 2.80 and a P/E of 20 times future earnings – not exactly what most would consider a “value.” What this means is that Buffett believes the company’s growth prospects are very attractive once the economy recovers.

Railroads do, in fact, have good operating leverage to an economic recovery since more than half of operating expenses are fixed – increases in rail volume would significantly enhance profit margins. Buffett also has a history of seeking companies with strong competitive advantages such as barriers to entry. The established network of nearly impossible to replace assets provides railroads with staggering barriers to entry.

Acropolis, too, has been buyers of railroads since March; however, we favor Norfolk Southern (NSC) due to its cheaper valuation, impressive profitability, diverse customer base, and commitment to returning value to shareholders. And since we are talking P/B ratios, NSC’s is only 1.82 compared to BNI’s 2.70.

The P/B ratio shouldn’t be the sole reason for making an investment decision. Like all valuation methods, it varies across industries and can be distorted by a company’s accounting methods in their financial statements. Still, the P/B ratio is a nice starting point for finding undervalued companies.

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Peter J. Lazaroff, Investment Analyst