An independent financial analyst has been investigating shares of Viirius Wavelength, a small fiber optics firm, for possible investment. This financial analyst has a history of value investing, and believes that shares of Viirius are not reflecting their "intrinsic value." In her analysis, this financial analyst has assimilated the following information for Viirius Wavelength:
Net Worth: $2,000,000 -
Number of common shares outstanding: 8,900,000
Current stock price: $11.63 per share
Earnings per share: $0.16 -
Using this information, what is the price-to-book ratio for Viirius Wavelength? Further, what is the price-to-earnings ratio using trailing earnings figures?
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The book value of a common stock is found by dividing the net worth of a company by the number of outstanding shares. While there exists several different methods for calculating net worth, the most simplistic involves subtracting total liabilities from total assets, giving us the shareholder's equity figure. The book value is often seen by investment professionals as a "floor" for common stock prices, and the price-to-book ratio is quite popular in the field of investment management.
The calculation of the price-to-book ratio involves the following equation:
Price-to-book ratio = {P0 / (Net worth / # of common shares outstanding)}
In this example, all of the necessary information has been provided. Imputing these figures into the priceto-book value equation will yield the following:
Price-to-book value = {$11.63 / ($2,000,000 / 8,900,000)} = 51.75.
Any time the price-to-book ratio is greater than one, a stock is said to be "trading at a premium to book."
Frequently, investment professionals will use the term "intrinsic value" when referring to the book value, as illustrated in this example. A figure of less than one for the price-to-book ratio is commonly referred to as "trading at a discount to book." Stocks trading below book value are often sought after by value investors, who believe the shares have been discounted below their liquidation value.
While the price-to-book value is a useful tool in the stock selection process, it possesses some important flaws. One problem with the Price-To-Book Ratio is that one of the terms - Book Value - is so easily manipulated. Valuation of inventory and real estate are easily adjusted on the books. Stock buy-backs and write-offs of exceptional items also deflate Book Value, making high priced stocks seem overvalued.
Since trailing numbers are to be used (i.e. earnings figures which have already been realized), the calculation of the price-to-earnings ratio is simple in this case - simply divide the market price by the EPS figure, which leads to a P/E of 72.69 for Viirius Wavelength.