Price to Book Value (P/BV) ratio is a measurement of how much an investor pays for a stock over its book value. Book value is the total tangible net assets in the balance sheet of a company after deducting its liabilities. In other words, it is the net worth per share.
Price to Book Value ratio compares the market price of a stock to its book value to assess whether the stock price is over the book value and by how much or whether it is trading below its book value. This ratio is used for any business that is asset heavy like infrastructure companies and is commonly used in the valuation of financial stocks.
Importance of the Price to Book Value for Financial Stocks
Book Value in a financial company
Since banks are in the business of lending money (from the money borrowed by them through your FDs), loans form the primary asset for them. Similarly, their primary liability is the deposits and other loans they have taken as their source of capital to lend. Loans being their primary asset, if a bank is indiscriminate in its lending, it can kill its balance sheet. To prevent this, there are RBI regulations on how much a financial company (especially banks) can lend based on its net worth. These guidelines come under what is called the “Capital adequacy ratio”.
Capital adequacy ratio is the proportion of a bank’s risk-weighted assets and current liabilities that it is required to maintain as capital. So, for example, if the capital adequacy required spelled by RBI is say 10% (illustrative purpose only) and a bank’s loans amount to Rs 100, then it needs to maintain net owned funds of at least Rs 10. In other words, a bank can lend up to say 10 times its capital (net-worth after certain statutory reserves) in this case.
Fine, so there is a cap on how much a bank can lend. But what happens if some of its loans go bad? Let us take the above example of Rs 100 loan book. Suppose 10% or Rs 10 goes bad. The bank will have to provide for this bad asset – also called non-performing asset (NPA). As a result, Rs 10 is reduced from the shareholder’s net worth. But then, Rs 10 was all that the bank had to begin with. In other words, its net worth is wiped out and in no time, an investor’s book value is reduced to zero. The bank’s very existence is in threat now.
This leads to panic among depositors, and de-stabilizes the whole working of a bank. Regulatory intervention and immediate re-capitalization (infusing fresh capital causing dilution) becomes a necessity, failing which the bank will go broke.
So, if the market perceives a threat that the book value will be eroded, the price of the stock remains cheap or may not move up. Hence the Price to Book Value (P/BV) will look low. Does that make the stock attractive? Not necessarily.
Let’s move to a more real-life example of Yes Bank to explain this further
In the data below, you will see a sudden jump in the equity capital of Yes bank in FY’20. Now isn’t equity capital infusion a good thing? Not in this case.
Look further below and you will see that NPAs skyrocketed that year. So, the net-worth was used to write off the bad assets. That means your book value got significantly eroded. However, regulations require that banks maintain a certain capital adequacy ratio. Hence, the bank had to pump in capital, diluting the earnings significantly.
What are the implications for a shareholder when such an event happens?
Let’s summarise it from the data above:
- The NPA has been written off from the existing book value or net worth. The erosion of net worth means existing investors get lemons
- For an investor who bought the shares at 2X or 3X the P/BV before the crisis, the wealth erosion would have been as high as 94-97%
- As seen in the data, even after the first round of capitalisation (5 times the earlier equity capital) the net-worth was lower than a year before
- After the second round of capitalisation in FY’21, with 10 times additional shares, the book value of the bank is now Rs. 14.67 per share versus Rs. 116 in FY’19
- With 10 times additional share capital coming in, the interest of existing shareholders has reduced to 1/10th
- Even assuming the bank reports the same profit as its best year in FY’17, the per share earnings (EPS) will be 1/10th of the earlier year due to the significant equity dilution
A high Price to Book Value (P/BV) does not necessarily mean high valuations. Market may be affording such valuation for high quality of book.
A low Price to Book Value (P/BV) need not necessarily mean a stock is attractive. The market may have refused to value the stock high due to concerns in the quality of book value. Hence, knowing the quality of the book value is more important than just the Price to Book Value (P/BV) as a measure.
A banking stock with an increasing trend of NPA is a red flag. Markets may be seeing this ahead of you and reduce the Price to Book Value (P/BV). This does not make it attractive unless the company has addressed the quality concerns in its book value.
The next time you see Price to Book Value (P/BV) among stocks, take a deeper look at the quality of their balance sheet.