Understanding the Price to Book Value

If you would like to buy a business place, let’s say a restaurant at the price of Rp1 billion, and you have the money, then what will you do? Of course you will buy it, right? But what if you only have Rp500 million? Then you can look for partners so that the money will be collected amounted to Rp1 billion. Let’s say you got two partners who respectively deposit Rp200 million and Rp300 million. Therefore, the revenue from the restaurant will be divided by three, where you will get 50%, and your partners respectively will get 20% and 30%.

The capital market principal is basically like that: To make a company with an exorbitant price can be held by many people at a low price, because you don’t have to buy the entire property, but only a small proportion of it. And then, the object called ‘the shares’ is created, which if you own it, then it means that you held a portion, either big or small, of the company’s ownership. So although you are just an investor with mediocre funds, but you can still relish the company’s income from the big companies such as Telkom (TLKM), Astra International (ASII), and others, according to the portion of shares that you have, in form of dividends.

The market capitalization aka the market cap, is basically the selling price of a company. For example, the restaurant exemplified above, we can say that the market cap of that restaurant was Rp1 billion. In the capital market, this price was split into millions or even billions of shares, so you can buy it at the low price. For example, Adaro Energy’ (ADRO) market cap today is Rp64.6 trillion. You don’t have that much money? No problem, because ADRO split the price into 31.9 billion of shares, so the price becomes Rp2,025 per share. So, with capital of only Rp2 million, you are able to buy 1,000 pieces of ADRO’s shares. It’s just that the dividends that you will get later will be in a small amount, so it can be said as worthless. If ADRO pay dividends of Rp100 per share (dividend yield of 5% is considered good), then you will only get Rp100,000 a year.

From the analysis above, we know that market cap is: The share price multiplied by number of outstanding shares. Thereby, if the price of certain share or the number of the outstanding share changes, then the company’s market cap will also change. The share price certainly can change anytime, especially if the shares liquid (actively traded). The number of outstanding shares can also change from time to time (not anytime) if the company did buyback, stocksplit, reverse stock, right issue, etc.

So what is the relationship between market cap and equity?

Equity is the net capital of a company, while asset is equity plus debt. Suppose you buy the restaurant with capital of Rp500 million, and because you cannot get a partner, then you owe the rest of Rp500 million to bank. Then, the restaurant has asset of Rp1 billion, consisting of Rp500 million of equity, and the rest is debt. What if not long after that, you want to sell the restaurant? It can be done in two ways: 1. The buyer pay Rp500 million and the incurred bank debt is diverted to the buyer, or, 2. The buyer pay in full Rp1 billion.

Because of that, ideally, a market cap is equal with the company’s equity. The higher the market cap compared to the equity or asset of certain company, then the more expensive the company’s price will be. Of course it doesn’t make sense if you sell the restaurant at a price higher than Rp500 million, while the restaurant has not operated yet, and hasn’t generated revenue. Unless the restaurant had generated net income that is added to the capital. For example after 1 year, the restaurant you owned is capable to generate net income of Rp200 million, where you take the Rp100 million , and you use the rest of Rp100 million for investment (open a new branch, or pay some of the bank debt, etc). Then, your restaurant’s equity is no longer Rp500 million, but Rp600 million. And whoever wants to buy your restaurant, then he or she will have to pay minimum of Rp600 million.

I said minimum because if you good at doing business, you can sell the restaurant at higher price, let’s say, Rp800million. How? Just said to the potential buyer that your restaurant will generate greater net income in the future. Let’s say for example: in the next year, this restaurant will re-generate net income of Rp200 million, so it is worth to be sold at the price of Rp800 million. If the potential buyer tempted, then congratulation! You are able to sell your restaurant at higher price or market cap from the equity. You don’t have to wait for one year to get net income of Rp200 million, but the buyer will.

And that's what’s exactly happened in the capital market. ADRO, for instance, its market cap amounted to Rp64.8 trillion is three times of its equity that is amounted to Rp18.3 trillion. If we use the rule that ideally, a market cap should be equal to its equity, the ADRO’s shares price should be Rp550 per share, and not Rp2,025 like now. Or if the second method to buy used (you buy the whole ADRO’s assets without having to bear the debts), then the shares price should be Rp1,300, where the price will generate market cap equal to ADRO’s assets’ value.

ADRO is not the only one. Most of other shares, particularly blue chips with good performance are also like that: The market cap is above its equity, it can be two or three times greater, or even more. ADRO is nothing when compared to UNVR, which in its current price (16,650), records market cap amounted to Rp127.0 trillion, or equal with 27.2 times of its equity. What makes the price soar that high? It is because the performance is very good, so it has very bright prospect. Yep! The shares price is a reflection of expectation of the investors on the possible generated profit in the future. Because by generating profit, the equity value will rise every year. Then it will be reasonable if a company with good performance has very high price or market cap compare to the net capital aka the equity.

And it is also reasonable if the company with poor performance (continues to have a negative net profit aka loss), its market cap is usually equal to its equity, or slightly below it, e.g 0.9 times, because the negative expectation that the loss would decrease the equity itself.

That’s why, a share is considered has low price, if the price generated market cap that is equal with the equity, or just slightly above it (it is almost impossible if the price is smaller than the equity, unless the company has very-very poor performance). So that this market cap can be used as one of the methods to calculate the fair price of certain share. So what if the price generated market cap twice or three times of its equity? It depends on: If the performance of the company is good, the price probably still not considered as high. But if the performance is poor, then the price is certainly considered as high.

On the fundamental analysis, the comparison between market cap and equity is known as PBV (Price to Book Value). Price is the market cap, while Book Value is the equity. For example is share A, with market cap of Rp100 billion, while the equity is Rp40 billion. Then, its PBV is 100 / 40 = 2.5 times. On the example of ADRO and UNVR above, we can say that the PBV respectively amounted to 3.6 and 27.2 times. The higher the PBV, the more expensive its shares will be.

Normally, the investors do not care although the shares price that they buy are too high, because they don’t target dividend, but the benefit of buying at the low price and selling at the high price. Why? Because as already explained above, the nominal amount of dividend usually very low compared to the shares price. Already so, it is distributed once a year only. Because it’s said that the capital market promises ‘generous profits at a glance’, then most of the investors preferred to trading their shares instead of waiting for the distribution of dividends.

When this article was written, JCI was on the position of 2,981. It seems only a matter of time before JCI reach 3,000. Do you know if the entire shares price are equated with the equity size respectively (the PBV is 1 times), then JCI probably will not reach 2,000? But well, welcome to the capital market, where prospect is everything!

Original article was written on July 15^th, 2010.