Price to book value is an important ratio which is used by many analysts for valuing a company. Some companies trade at higher price to book value, some trade at lower. Book value is the value of equity, therefore what price to book value multiple a stock will get depends a lot on how much return the company is making on the equity capital.
Below is a method to judge the fair price to value of the company from its Return on equity. Its called the PB-ROE method. This method takes into consideration growth, cost of capital and ROE.
Growth: Here we will take the self-sustainable growth, which is the growth that the company can achieve without raising any further capital. It is calculated as
g = (1 – Payout ratio) * ROE
The payout ratio is the dividend payout which the company is making. We are taking here are the capital that will be left with the company after making the dividend payment. On mulitplying it with the company’s return on equity we get the self sustainable growth
Cost of Equity: Equity capital has some cost. The general cost of equity is
Cost of Equity C = risk free rate of return + risk premium
risk free rate of return is the return from FD or goverment bonds , the risk premium is the excess minimum return that we deserve for taking the risk of investing in equities. Can take it 5%
Cost of equity = 7=5 = 12%
Now the right P/B multiple can be calculated as
Price/Book Value Ratio = 1+ (ROE – g) / (C – g)
Lets take the case of Maruti
Current ROE is 16.3% and payout ratio is 31%
this gives the sustainable growth rate r = 16.3(1- 31%) = 11.2%
Price/Book Value Ratio = (16.3 – 11.2) / (12 – 11.2) = 6.3
The current book value of the company is 1382 on multiplying it with 6.3 we get 8700 as the fair value of the company
Lets take another case of Marico
Current ROE is 31% and the payout ratio is 67%
this gives the sustainable growth rate r = 31(1- 67%) = 10.2%
Price/Book Value Ratio = (31 – 10.2) / (12 – 10.2) = 11.5
the current book value is 23.6 , the share price become 23.6*11.5 = 272
Note: This method can be used only for companies with stable ROE and sustainable growth.
Abhishek is an Engineer MBA in Finance and Certified Research Analyst. He is an active trader and investor in the stock market since 2010. Follower of the philosophies of Warren Buffet and Peter Lynch in investing and trend following in trading.