Question

Is book-to-market ratio a factor?

A. Yes

B. No
C. Does it matter?

Answer 1

Hi,

Yes, the book-to-market ratio is a factor. Thus, the answer is A - Yes.

Book value of any company is value as on date. The major drawback is that it does not consider the future earning potential of the company which DCF or other income methods do. Thus, this factor, will give a sense on how a company is looked upon by the investors. This is predominantly relevant in two scenarios:

1. Balance sheet driven sectors: E.g. Banking and Financial Services: In such cases, loans books derive the future valuation
2. Asset heavy industries: E.g. Manufacturing sector. For these companies, order book is the key element which is recorded on their asset side of balance sheet.

However, we can use this factor/multiple for other industries as well. It is important to note that, all assets should be recorded in books using similar accounting principles to have meaningful comparison across industry.

This concept is similar to mark-to-market for investments.

Case 1: Assume a case where you are a shareholder of the company and you want to sell of this company? At what rate will you sell? You will def not sell at book value, but higher than it. How do you derive this? Book-to-market valuation multiple will help you here.

Case 2: Raising funding for start-up: In this case, entire valuation is driven by future events. There is hardly anything on balance sheet as on today. So arrive at true valuation, we need to arrive at fair/market value of all assets (including intangible assets).

Thus, there are 2 ways to do book-to market.

1. Apply industry multiple.
2. Arrive at market value of each asset (and deduct market value of liability)

In my opinion, thus, book-to-market is definitely a factor which is primarily used for valuation purpose

Hope this answers your question