Economic price to book

What Is Economic Price to Book?

Economic Price to Book is a financial analysis metric that compares a company's current Market Value to its "economic" book value, rather than its accounting book value. While traditional book value is derived from a company's Balance Sheet according to Accounting Standards, economic book value seeks to represent the true Intrinsic Value of a company's net assets, often incorporating elements not fully captured by historical cost accounting. This approach aligns more closely with Valuation methodologies that aim to reflect a business's real economic worth and its future earning potential.

History and Origin

The concept of economic book value, and by extension, the Economic Price to Book, stems from a recognition of limitations within traditional accounting frameworks. Historically, financial reporting primarily relied on the historical cost principle, where Assets and Liabilities were recorded at their original acquisition cost. However, as economies evolved, particularly with the rise of knowledge-based industries, the importance of unrecorded or understated assets grew.

The shift towards "fair value accounting" has been a significant development in modern financial reporting, aiming to provide more relevant information by valuing assets and liabilities at prices they would command in an active market. This movement gained traction with the issuance of standards like IFRS 13 and GAAP FAS 157, which mandate or permit the use of fair value measurements for various financial statement components.⁵ Despite these changes, a substantial gap often remains between a company's accounting book value and its true economic worth.

Academics and practitioners, such as Professor Baruch Lev, have highlighted how traditional accounting's inability to fully capture Intangible Assets (like brands, patents, and research & development) renders conventional book value increasingly irrelevant for valuation purposes.⁴ Estimates suggest that U.S. firms invest at least $1 trillion annually in intangible assets, a figure that rivals investment in tangible assets.³ This divergence has underscored the need for metrics like Economic Price to Book that attempt to bridge the gap between reported financials and underlying economic realities.

Key Takeaways

• Economic Price to Book compares a company's market capitalization to its estimated economic book value.
• Economic book value reflects the true intrinsic worth of a company's assets, often going beyond historical costs.
• This metric seeks to address the limitations of traditional accounting in capturing the full value of Intangible Assets.
• A lower Economic Price to Book might suggest a company is undervalued relative to its economic reality.
• Calculating economic book value requires extensive analysis and often relies on forward-looking estimates.

Formula and Calculation

The Economic Price to Book is calculated by dividing a company's market price per share by its economic book value per share.

Where:

• Market Price per Share: The current trading price of one share of the company's stock. This represents the collective judgment of investors on the company's worth.
• Economic Book Value per Share: This is not a readily available figure on standard Financial Statements. It represents an analyst's or investor's estimate of the true per-share value of a company's net assets. It often involves adjusting the accounting book value for:
  • Unrecognized Intangible Assets: Such as brand value, intellectual property, human capital, or internally developed research and development that are expensed rather than capitalized under GAAP or IFRS.
  • Fair Value Adjustments: Revaluing recorded Assets and Liabilities to their current fair market values, rather than historical costs.
  • Off-Balance Sheet Items: Including obligations or assets that do not appear on the traditional Balance Sheet but have a material economic impact.
  • Goodwill Adjustments: Reassessing the true value of goodwill, especially if it is impaired or has unrecognized economic value.

Estimating Economic Book Value often involves sophisticated Discounted Cash Flow (DCF) models, asset-based valuation techniques, or other comprehensive Valuation approaches.

Interpreting the Economic Price to Book

Interpreting the Economic Price to Book involves assessing whether a company's market valuation accurately reflects its underlying economic worth. A ratio close to 1 suggests that the market price is roughly in line with the estimated economic value of the company's net assets.

• Economic Price to Book < 1: This may suggest that the company is undervalued by the market relative to its true economic assets. This could indicate an investment opportunity if the market is failing to recognize the full value of the company's Intangible Assets or other unrecorded economic benefits.
• Economic Price to Book > 1: This indicates that the market assigns a higher value to the company than its estimated economic book value. This premium often reflects investor expectations for future growth, strong Profitability, a robust economic moat, or other qualitative factors not fully captured in the economic book value calculation itself.
• Economic Price to Book = 1: This implies that the market price aligns perfectly with the estimated economic book value, suggesting the company is fairly valued based on its economic assets.

Unlike traditional Price-to-Book ratios, which can be distorted by accounting conventions, the Economic Price to Book attempts to provide a more realistic snapshot of value. However, its accuracy heavily depends on the rigor and objectivity of the economic book value calculation.

Hypothetical Example

Consider a hypothetical software company, "InnovateTech Inc." Its reported Balance Sheet shows a book value of \$50 million. However, InnovateTech has developed proprietary AI algorithms, a strong brand, and a highly skilled workforce, none of which are fully captured at their economic worth in its traditional accounting book value.

An analyst, using advanced Valuation models, estimates that the true economic value of InnovateTech's net assets, including its intellectual property and brand recognition, is actually \$150 million. InnovateTech has 10 million shares outstanding.

1. Calculate Accounting Book Value per Share: \$50 million / 10 million shares = \$5.00 per share.
2. Calculate Economic Book Value per Share: \$150 million / 10 million shares = \$15.00 per share.

Now, assume InnovateTech's current Market Value is \$20.00 per share.

• Traditional Price-to-Book Ratio: \$20.00 / \$5.00 = 4.0x
• Economic Price to Book: \$20.00 / \$15.00 = 1.33x

In this example, while the traditional Price-to-Book ratio of 4.0x might suggest the company is highly overvalued, the Economic Price to Book of 1.33x provides a different perspective. It suggests that once the unrecorded economic value, particularly from Intangible Assets, is considered, the market's premium is less extreme and might be justifiable given the company's future growth prospects.

Practical Applications

Economic Price to Book is a valuable tool in several areas of Financial Analysis and investing:

• Fundamental Analysis: It provides a more nuanced view for fundamental analysts seeking to understand a company's underlying worth beyond its reported Financial Statements. This is particularly relevant for companies with significant Intangible Assets or those operating in rapidly evolving industries.
• Mergers and Acquisitions (M&A): In M&A deals, the acquiring company is often paying for the economic value and future synergies, not just the accounting book value. Economic Price to Book helps acquirers and sellers assess the fairness of a deal price relative to the target's true economic base.
• Portfolio Management: Fund managers who focus on deep value or those investing in companies with high intellectual capital may use Economic Price to Book to identify mispriced opportunities.
• Credit Analysis: While less direct, understanding the economic book value can provide insights into the real asset backing of a company, which can be relevant for assessing its solvency and creditworthiness.
• Equity Research: Equity research firms like Morningstar, which often emphasize intrinsic value derived from Discounted Cash Flow (DCF) models, implicitly adopt an economic book value perspective when assessing a company's "fair value." Morningstar's approach focuses on a company's future cash flows to determine its intrinsic worth, moving beyond reliance on simple financial ratios for valuation.²

Limitations and Criticisms

While Economic Price to Book aims to offer a more accurate valuation perspective, it is not without limitations. A primary criticism lies in the inherent subjectivity involved in calculating economic book value. Unlike accounting book value, which adheres to standardized Accounting Standards (GAAP or IFRS), economic book value relies heavily on assumptions, estimations, and the judgment of the analyst. Different analysts may arrive at vastly different economic book values for the same company, leading to varying Economic Price to Book ratios. This can introduce a lack of comparability across analyses.

Furthermore, the very factors that necessitate economic book value—the importance of Intangible Assets—are often the most difficult to quantify accurately. Valuing elements like brand equity, proprietary technology, or customer relationships can be complex and prone to overestimation or underestimation. Professor Baruch Lev, a noted critic of traditional accounting, points out that the increasing investment in intangibles has diminished the usefulness of conventional book value and earnings as indicators of a company's worth, suggesting that accounting deficiencies contribute to the misidentification of value. Thi¹s challenge highlights the speculative nature that can accompany attempts to fully capture economic value.

Investors must also be wary of using Economic Price to Book in isolation. A low ratio might simply reflect a market's accurate assessment of risks, rather than an oversight of economic value. Conversely, a high ratio might be justified by truly exceptional, sustainable competitive advantages. The metric does not guarantee future investment outcomes or stock performance.

Economic Price to Book vs. Price-to-Book Ratio

The distinction between Economic Price to Book and the traditional Price-to-Book Ratio lies fundamentally in their denominators: the definition of "book value."

Confusion often arises because both metrics use "book value" in their name. However, the "economic" qualifier in Economic Price to Book signifies a departure from the strict accounting definition, aiming for a more holistic, intrinsic view of value that considers what the company's assets would be worth if realistically valued or what future cash flows they could generate.

FAQs

How does Economic Price to Book differ from Enterprise Value (EV) to Book?

Economic Price to Book focuses on the economic value attributed to Shareholders equity. Enterprise Value (EV) to Book, on the other hand, considers the entire value of the company (both equity and debt) relative to its total book value of assets (or total capital), providing a perspective independent of capital structure. Both aim to go beyond simple accounting figures, but EV considers all capital providers.

Is Economic Price to Book useful for all types of companies?

Economic Price to Book is particularly useful for companies where the accounting book value significantly understates the true economic worth, often due to substantial Intangible Assets or unrecorded intellectual property. This includes technology firms, pharmaceutical companies, and consumer brands. For asset-heavy industries like manufacturing or utilities, the traditional Price-to-Book Ratio might still be a more straightforward and relevant metric.

Can Economic Price to Book be negative?

No, Economic Price to Book cannot be negative. While accounting book value can sometimes be negative if a company's Liabilities exceed its Assets (negative shareholder Equity), economic book value, by its nature as an estimate of underlying worth, would generally not be negative as long as the company has a positive market price and some viable economic activity. The market price itself is always positive.

How often should Economic Price to Book be recalculated?

The market price component changes continuously, but the underlying economic book value changes less frequently. A full recalculation of economic book value would typically be undertaken when there are significant changes to the company's business model, strategic assets, competitive landscape, or when new Valuation data becomes available. Periodic reviews, perhaps annually or semi-annually, are common to ensure the economic book value estimate remains relevant.