This is something about using price to book to value a stock and and I just feel like writing it down. It is also to share with my personal friends.
I have been seeing a lot of people using price to book ratio to value a stock and the problem with such a ratio has many deficiencies. In accounting, a constant issue is always the difficulty in relevance vs reliability. I will give a few examples here.
Relevance vs Reliability
Your parent bought a HDB flat for 50k 30 years ago, the current value now is 300k. How much should we record the value of the flat. 50k is the more reliable figure as that was indeed the cost paid and supported by all the transaction documents. 300k is the current valuation report. However, valuation can be determined by the current market sentiment, replacement cost (price to buy a similar unit) or the cost to build an exactly same flat. These costs change from time to time which brings about a range of value to an asset during different period. Hence you always hear people say valuation is an art, not a science. There is nothing precise about it.
Different financing Cost
In accounting, you are allowed to capitalise the cost to build the asset including the finance cost until the asset is ready for use. This means someone with a financing cost of 5% will have an higher asset value than someone with 3% borrowing cost. In essence both are the same thing. Capitalisation is purely classification of expense as an asset and allocating the expense in the period you expect the benefit to be consumed. An example will be renovation of your house which maybe cost 50k and you capitalised it and depreciate 5k a year for 10 years due to your estimation that you need another renovation 10 years down the road.
Depreciation
Depreciation itself is an arbitrary cost allocation exercise. If a company choose to depreciate their asset over 5 years vs another company who does it over 3 years, the former will show higher profit margin and higher net asset value. The question here to ask is whether the former is too conservative or the latter too aggressive. The tell tale is whenever the company make a disposal, check the gain/loss on disposal. A huge gain indicate that there is the likelihood that management is too conservative. The actual profit margin of the company could be higher.
Capital intensive vs capital light business model
Generally, manufacturing businesses are considered capital intensive and hence their book value is always higher vs service industry business. That is due to the raw material, plant and machinery that are involved in the business. You cannot use book value to value business such as Raffles Medical. It is like telling RMG management I will pay for your hospitals and equipments and I get your branding, doctors and nurses skills for free. I have seen some posts who measure RMG using book value and it made my day. Thanks.
Stuffs not capitalised
Stuff such as branding, your distribution network, technical know how etc are all stuff which are esssential to a business and considered important. However, they are all not capitalised. For example, I don’t think Apple put a value on Steve Jobs on their balance sheet. And companies always say people is our greatest asset. The irony of it. Time to knock on management door and tell them to “value” and capitalise you. LOL.
The list is not exhaustive but these are the more common one i can think of. Thanks for reading.
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