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When To Use Book Value To Value A Stock?

Book value has been a popular method to value a stock because there is not much calculation involved in calculating the book value of a company. The figure is also readily available in a company’s annual report.

This means that investors can simply use the book value per share of the company and compare it with the market value per share of the company. The investor can then make a decision of whether the company is undervalued or overvalued.

However, because book value is a simple method to use, it can easily be abused as well. We have to understand that book value might not be relevant for all companies. This is because what the company reports on its book value might not be a current representation of the actual value of the company. It is merely an accounting book value. Its assets might include machines or obsolete inventories that are still accounted for in the balance sheet but are worthless in real life.

It would make little sense to still use the price-to-book ratio (P/B) to measure the value of such companies.

In fact, P/B ratio might only be useful if we are valuing companies that have assets that are reflective of the actual value of the company.

For example, companies that regularly revalue their assets to make sure their balance sheet are up-to-date or companies with valuable assets that do not lose their value over time may be good candidates for using the P/B ratio.

Here are three sectors where investors can use P/B ratio to value the companies.

Banks

Banks tend to have liquid assets such as cash and loans that are regularly updated in their valuation. This means that the balance sheet book value of a bank might be quite representative of the actual value of the company.

Real estate investment trusts (REITs)

REIT is also a good asset class to be measured using P/B ratio. This is because most REITs would revalue their properties regularly to ensure that their balance sheet is up-to-date. This means that its accounting book value is quite similar to its actual investment book value.

Foolish Summary

P/B ratio is a fast and simple method of valuing a company. However, due to its ease of use, it is also prone to abuse by an investor.

We have to understand that the P/B ratio might not be relevant for all types of companies and be aware of how it might impact our valuation when we are using them.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.