Is there a reason why metal companies, like Tata Steel and SAIL trade at such low prices compared to their book value? Even the industry P/B seems to be low. What am I missing?
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1There are various reasons for it but most probably because investors don't think it's worth as per book value.– Stupid_InternJan 30, 2020 at 18:51
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1 Answer
Price to book value (market cap/Book value) is actually a metric of:
PE x ROE which is equal to :
(price/earnings) x (earnings / equity) where equity = net book value (asset-libailbities)
therefore another way to write this is:
(ROE – g) / (r – g)
where g is the growth rate and r is the cost of equity/required rate of return.
If we assume a zero growth rate, the equation implies that the market value of equity should be equal to the book value of equity if ROE = r.
Price/Book value will be higher than 1 if a company delivers ROE higher than the cost of equity, and below that if the return is lower than the cost of equity.
Another way to look at this is that if a company is losing money and is projected by the market to continue to lose money, then it should trade for LESS than the assets are currently worth because they will continue to erode in the future (versus increase, which generally fetches a premium to book value).
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1"Book value will be higher than 1" -> "Ratio of price to book value will be higher than 1", right? Also, in the case of losses, shouldn't it be difficult for the ratio to go much below 1 because the company has the option to liquidate? You might want to explain why companies with ratios below 1 don't liquidate, either voluntarily or via a takeover.– nanomanJan 30, 2020 at 21:35
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They can liquidate, of course, but in reality, they often don't as a result of the cost of listing.... liquidation is also expense (i.e. needs to be discounted to "book value"to liquidate ) in the case of equipment and machinery it can be very high (i.e. forced liquidation value of in-place as is equipment can be 20% of the book carry value-- ]that is the value on the financial statements). I would say price won't often go much below CASH +cash equivalents, but that isnt book value. Jan 30, 2020 at 22:43
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Sorry for the late reply, but being a novice to the subject I spent some time reading some of this on my own. I still don't understand how you get PB = (ROE – g) / (r – g). Could you add the missing steps?– NoelJun 6, 2020 at 6:30
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you can look up "justified price to book derivation", here is a link to a longer explanation and another forum: analystforum.com/t/do-not-understand-derivation-of-p-b-formula/… Jul 4, 2020 at 1:12