The Price to Net Asset Value ratio

In some of my articles over recent years, I explained certain financial metrics to assist retail investors to understand those ratios which are used across all the international media and also found on many websites and publications locally.

One of the most commonly used multiples is the price to net asset value or book value. This ratio is one of the key metrics used by value investors. One of the most renowned value investors, Warren Buffett, is a firm believer in the price to book value multiple and in fact he makes reference to Berkshire Hathaway’s change in the book value per share at the start of each of his annual letters to shareholders.

Net asset value or book value represents a company’s assets minus its liabilities and very often it is referred to as shareholders’ funds or equity. Another way of explaining the net asset value is the amount of money that shareholders would theoretically receive if a company liquidates all its assets after paying off all its liabilities.

The net asset value or book value per share is used to calculate the per share value of a company based on the overall level of shareholders’ funds. The price to net asset value is then derived by dividing the share price with the company’s net asset value per share.

Traditionally, a price to book ratio below 1 is a good multiple since it potentially indicates that the shares are undervalued. However, it could also mean that something is fundamentally wrong with the company. As such, similar to all other financial ratios, the price to net asset value ratio should be complemented with other metrics when evaluating the attractiveness or otherwise of a company’s shares.

As with most ratios, the values may differ significantly across various industries. The price to net asset value is best used for asset-rich companies, such as banks and other financial institutions, manufacturing companies and other capital-intensive industries. On the other hand, service-based companies do not have significant assets on their balance sheet and therefore the price to book value multiple is not a good financial metric. In Malta, there are several banks, insurance companies and property-based companies and therefore the price to book value multiple is a very useful indicator. On the other hand, there are some service-based companies listed on the Malta Stock Exchange (most notably RS2 Software plc and Medserv plc) and in these cases, earnings based multiples are more important.

Since a bank’s assets (investments and loans) as well as its liabilities are periodically revalued (or marked to market), their assets and liabilities represent the market value or a fair indication of the underlying value. As such, the price to book value ratio is mostly used for valuing bank shares. In recent years, the price to net asset value ratios of most European banks dropped to well below 1 due to the concerns on the high level of non-performing loans. Meanwhile, most banks in Malta trade at a premium to the net asset value largely on account of the relatively low level of non-performing loans as well as the higher returns on equity being generated by them compared to their European counterparts.

The return on equity is a common profitability ratio used in conjunction with the price to book value ratio. The denominators of both these metrics are in fact identical. The ROE measures the profit generated by a company from the amount of money invested by shareholders and it is calculated by dividing the annual profit figure by the average level of shareholders’ funds. On the other hand, as I explained above, the price to book value ratio shows the relationship between the share price and the net asset value. Companies which have low returns on equity or are loss-making generally tend to have a low price to book multiple.

The general rule of thumb is that a low return on equity and a high price to book value ratio indicates that a company’s shares are overvalued. On the other hand, a high ROE coupled with a low price to net asset value ratio generally shows that a company’s shares are undervalued.

Companies within certain sectors such as the insurance industry trade at low price to net asset value multiples due to the cyclical conditions of that industry mainly related to unpredictable natural disasters which may result in large payouts to policyholders. In Malta, there are only two insurance companies listed on the Malta Stock Exchange. Mapfre Middlesea plc currently trades at almost twice its book value per share while commanding a single digit return on equity. On the other hand, GlobalCapital plc had an ROE of 16.5% in 2016 and trades at a significant discount to its net asset value. This may be explained by the intention of the company to conduct a €15 million rights issue.

Investors and financial analysts have to exercise great caution when interpreting the price to net asset value of real-estate or property development companies. The assets of these companies are generally not valued on an annual basis. As such, while some assets may indeed still be reported at the original cost thereby not reflecting their true values other assets that are revalued periodically may become overstated should the economic environment rapidly deteriorate.

At times of high economic growth and rising property values, certain assets on the balance sheet of a property company may potentially be understated. This may be the case for MIDI plc given that the business centre (50% owned by MIDI) due to open shortly is still valued at cost. Moreover, Manoel Island is valued at €40 million. The possible value of this large parcel of land assuming planning permission is granted could be significantly higher in the future thereby possibly boosting its net asset value.

Some critics argue that the price to net asset value multiple fails to factor in any future earnings prospects of the companies. Other critics claim that the value of intangible assets can distort the measure of the price to book value ratio given the complexities in valuing such assets. Last week’s announcement by 6pm Holdings plc should be a very good eye-opener for Maltese investors in this respect.

Goodwill is one of the most common forms of intangible assets. Goodwill created following the acquisition of a company can easily inflate the book value of the company. Some analysts therefore prefer assessing a company’s tangible net asset value, which excludes the value of intangible assets such as goodwill.

Although the price to book value multiple is a very useful measure, it should not be used in isolation and as explained above the return on equity is another important ratio to consider in conjunction with the price to net asset value. Investors and financial analysts therefore use various metrics when selecting which companies to gain exposure to, most notably the price to earnings multiple or the EBITDA multiple. Based on these various valuation metrics, some clear conclusions can also be drawn on many of the companies listed on the MSE. While such conclusions are invariably always subjective thereby giving rise to contrasting views, this helps in the orderly conduct of trading on the secondary market where buyers and sellers trade their shares.

Activity across the Maltese equity market has improved markedly in recent months. Despite this evident increase experienced in certain equities, institutional investors and high net worth individuals holding sizeable positions in certain companies also have a very important role to play to ensure that an active secondary market continues to develop. In the absence of market makers, institutional investors and high net worth individuals need to assume responsibility for helping to create an active secondary market by assisting buyers to enter the market and likewise by quoting a price to enable sellers to exit their positions. In essence, a more liquid secondary market is a very positive development for all types of investors.

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