Market Value vs. Book Value of Equity Securities

The book value of a company’s equity reflects the historical operating and financing decisions of its management. The market value of the company’s equity reflects these decisions as well as investors’ collective assessment and expectations about the company’s future cash flows generated by its positive net present value investment opportunities.

As such, book value only looks at the company’s past, while market value should be based on the company’s future. If a company has a high price-to-book ratio (market price per share divided by book value of equity per share) relative to its industry peers, the market likely has high growth expectations for the company. It doesn’t make sense to compare the P/B ratios of companies within different industries because market prices also reflect the growth opportunities of the industries as a whole, which may differ significantly.

Question

$$
\begin{array}{l|r}
\textbf{Company} & \textbf{P/B} \\
\hline
\text{Toyota} & 1.25 \\
\text{Ford} & 1.58 \\
\text{Tesla} & 11.65\\
\end{array}
$$

Based solely on the P/B ratio, which auto company is likely to have the least attractive opportunities for growth?

1. Ford.
2. Tesla.
3. Toyota.

Solution

The correct answer is C.

Because Toyota has the lowest current P/B ratio, the market is placing the lowest value on the company’s future growth opportunities. On the other hand, the market has high growth expectations for Tesla.