- Book value is often an important number for the fundamental investor and is used to calculate metrics like Price to book value ratio.
- The assets of Internet companies are often intangible in nature, and do not appear on balance sheets, which leads to lower book value per share and higher price to book ratio.
- The higher price to book ratio of technology companies could often lead to missing out on some good investments. Therefore, the relevance of book value for internet companies can be questioned.
Book value of a company usually consists of total assets less total liabilities. This is often used by traditional value investors in aiding their investment decisions, in the form of the price to book value ratio. The price-to-book value ratio can be calculated in two different ways; on a per share or aggregate basis. On a per share basis, it is given by the following formula:
Price to book value ratio = Stock price/Book value per share
On an aggregate basis, it can also be calculated using the following formula:
Price to book value ratio = Market capitalization/total book value
Price to book value ratio has been a very important tool in the investment toolkit of traditional value investors. The traditional investment methods look for companies with low price-to-book value ratio and invest in these for the long term, with an underlying belief that the market will eventually value these companies for what they are worth, leading to gains in the stock price over the long term. These methods, which form key part of value investing philosophy, often look for companies trading at a price lower than their book value of equity, or a price to book value ratio of less than 1.
However, the high growth and often lucrative technology stocks usually have a higher price to book value ratio due to the following reasons.
- Assets created by technology companies are usually intangible in nature, which often do not find a place at all in the balance sheet.
- Also the intangible assets of technology companies, like patents and software, often appreciate, which is not reflected in their book values.
For example: Google’s patented search algorithm would be worth billions of dollars today, but does not find a place on Google’s balance sheet as it was developed in house by Google. Similarly Google would have acquired the Android operating system for a few million dollars which would be worth billions today. Another example could be Airbnb’s platform which can handle a huge number of listings and bookings, which is a key asset for the company. However, the same will not find a mention on the company’s balance sheet though Airbnb pre-IPO valuation is currently $13 billion.
To clearly understand the difference between the book value ratio for internet companies and others, we compare the book value ratio of Facebook and Google (Internet companies) to General Motors (Auto) and Bank of America (Financial sector).
|Book value ($B)||Market Capitalization ($B)||Price to book value ratio|
|General Motors (GM)||43.56||53.71||1.23|
|Bank Of America (BAC)||239.08||179.19||0.75|
As seen above, the price to book value ratio for Google and Facebook is significantly higher than that of general motors and Bank of America. This is because general motors has higher amount of tangible assets as compared to the intangible assets of Google and Facebook which are not reflected on the balance sheet of these companies. On the same note, the price to book value ratio is lowest for Bank of America as Assets are largely tangible and financial in nature which makes them easier to value even compared to fixed assets. Hence, the market tends to value financial institutions close to their book values. However, in case of internet companies, the intangible nature of Assets makes it difficult to value these assets and makes the price to book value ratio redundant to that extent. Inability to accurately value intangible assets has been one of the major limitations of the price to book value ratio, and in the case of internet companies, this limitation clearly comes to the fore.
Hence, using price to book value ratio to value internet companies could throw off an investor. While it can be used in comparison to other internet companies, we think it would be better to look at internet companies valuations through the lens of PEG ratio (price/earnings to growth ratio). This metric takes into account not only the earnings but also the rate of earnings growth, which makes comparisons more accurate. This leads to better understanding of the risks associated with stocks.
In conclusion, price to book value ratio used to measure internet company valuations could be hugely misleading, on account of huge amount of intangible assets created by internet companies. Therefore, it would be better to look at all other metrics as well, which could lead to a better understanding as to how to value internet companies effectively.