Book values measurement determines the price-to-book ratio.
To evaluate the price-to-book ratio, we must understand how book values are measured.
The values of some assets and liabilities are easy to measure, and the accountant does so. He applies
mark-to-market accounting, thus recording these items on the balance sheets at fair value (in accounting terms). These items do not contribute to the premium over book value.
But for many items, the accountant does not, or cannot, mark to market. He applies
historical cost accounting. U.S. GAAP gives measurement rules for items commonly found on balance sheets, with those carried at fair value and historical cost indicated. International accounting standards broadly follow similar rules.
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Example:
Company A Balance Sheet
Cash and cash equivalent $7.764 million
Short term investments $208 million
Long term investments (mainly interest bearing debt securities) $1,560 million.
Comment: A market value is usually available for these securities, so they can be
marked to market.
Accounts payable $11,492 million
Long term debt $362 million
Comment: The accounts payable is
close to market value and, while the long-term debt is
not marked to market, its book value approximates market value unless interest rates change significantly.
So all these items above do not contribute to price premium over book value.
Net accounts receivable $5,961 million
Financing receivables $1,732 million
Accrued expenses $4,323 million
Other "liabilities" $2,070 million
Comment: All the above 4 items involve
estimates, but if these are made in an unbiased way, these items, too, are at fair value.
Company A
2,060 outstanding shares
Market Price $20 per share.
Market value of these shares: $41,200 million.
Book value $3,735 million
Therefore the market premium was $37,465 million.
Comments:
The market saw $37,465 million of shareholder value that was not on the balance sheet.
And it saw $37,465 million of net assets that were not on the balance sheet.
With 2060 million shares outstanding,
- the book value per share (BPS) was $1.81 and
- the market premium was $18.19 per share.
How does one account for Company A's large market premium of $37,465 million over the book value of its equity?
The large market premium of $37,465 million over the book value of its equity arises largely from
- tangible assets, recorded at (depreciated) historical cost, and
- unrecorded assets.
The latter are likely to be quite significant. Company A's value, it is claimed, comes not so much from tangible assets, but from
- its innovative "direct-to-customer" process,
- its supply chain, and
- its brand name.
None of these assets are on its balance sheet.
- Nor might we want them to be.
- Identifying them and measuring their value is a very difficult task, and we would probably end up with very doubtful, speculative numbers.
