Editor's note: Welcome to "Booyah Breakdown," an explanation of certain terms and topics Jim Cramer discusses on his "Mad Money" TV show. Feel free to ask a question if you're confused about something Cramer talks about, but please keep in mind that we do not provide advice on specific stocks.
Shopping for stocks is a lot like shopping for cars. What you're in the market for will depend on how you evaluate your options.
Let's say you're looking for, oh, I don't know, a
Lamborghini Gallardo or a
Ferrari F430 (Isn't everyone?). You're clearly concerned about the superb transmission, the massive gripping and, more importantly, how your date will react when you pull up in it.
If you're in the market for -- ugh -- a minivan (welcome to my world), you could use sex appeal as a valuation method, but it won't get you very far. You're probably much more concerned about its airbags, its ability to seat your kid's entire soccer team and the keypad's ability to not only to open the doors, but possibly pour the kids' drinks and stop the sibling squabbling.
Picking stocks is pretty similar. Certain stocks meet certain needs for your portfolio, and there are many different valuation metrics out there that can help you make the right choices.
And while you should consider all of them -- just because I drive a minivan doesn't mean I don't have sex appeal! -- some metrics just hold more relevance in certain industries.
This brings me to a topic I've received a lot of emails about. Jim Cramer has said on "Mad Money" that he won't buy certain companies that were trading at more than two times book value. Back in April, when a caller asked about
, he said, "It sells at less than two times book. ... good service, good people, you hold onto it."
That's because calculating the book value, and the corresponding price-to-book ratio, of financial stocks is a great way to analyze them. "Booyah Breakdown" is going to tackle that rationale for you today.
To watch Tracy Byrnes' video take of this column, click here
And be sure to keep
sending your Mad Money questions. We'll continue to help you understand the ins and outs of the market -- and maybe you can help me understand how I ended up in a minivan.
Show Me Your Hard Assets
In simplest terms, the book value of a company is its assets minus its liabilities. So, that would mean it's synonymous with shareholder's equity (assets minus liabilities equal shareholder's equity or net worth, which you can determine by looking at a company's
But many would argue that's not entirely accurate.
True book value doesn't include intangible assets, like goodwill. So, to accurately calculate book value, subtract all intangible assets from total assets. What you're left with is the nuts and bolts of the company -- the stuff you can touch -- like the buildings, computers, telephones and office chairs. For this reason, book value is sometimes also called "net tangible assets."
But it's basically what's left if the company was liquidated today, says Bob O'Hara, vice president of development at investment-education organization BetterInvesting. Keep in mind, though, that book value often reflects what an asset was worth when it was purchased moons ago. It doesn't reflect its current market value. So be sure to use your book-value calculation just as a baseline.
Ideally, you should crunch this number yourself. Realistically, you're probably going to click over toYahoo! Finance or your favorite stock site and put in your company's ticker.
At Yahoo! Finance, go to the "key statistics" section and scroll down to book value per share,all nicely calculated for you.
If the book value is higher than the stock price, the stock might be undervalued, and you could have a buying opportunity, says Dan Noll, director of accounting standards at the American Institute of Certified Public Accountants. But before you jump the gun, scroll up to the price-to-book ratio in the same section.
The price-to-book ratio measures what the market is willing to pay for your company's book value. A low price-to-book value could mean the stock is a bargain. A higher price-to-book could mean the market is putting a premium on your stock. It's willing to pay more because it's betting on future growth.
Here's a quick math lesson: While the price-to-book ratio is already calculated for you on many sites, you should understand what goes into it. To determine the figure on your own, divide the company's book value by the number of shares outstanding. That's your denominator. The current stock price is your numerator. Divide those two numbers.
But just like the book value calculation is most appropriate with companies that have hard assets, like factories or equipment, the price-to-book ratio follows suit. That's why it's a good measure for banks and insurance companies that have a lot of financial assets because they either have the cash, or they don't. And in these sectors, you'd like to see a lower price-to-book ratio.
So that's probably why Cramer used price-to-book to evaluate ISBC and then
back in March, saying, "I'm putting a sell on it because it sells at more than two times book."
And it's also most likely why he likes
, as its price-to-book ratio hovers around 2 as well.
But just like the number of cup holders is completely irrelevant when looking at the Gallardo(clearly important in the minivan, though), price-to-book isn't a deal breaker in other industries.
For instance, it's not important for companies that rely heavily on intellectual assets, such as patents, trademarks, or even their employees' brains. That stuff doesn't show up on the balance sheet.
Those companies indirectly end up with low book values because those seemingly important"assets" aren't reported. And low book value generally translates into an inaccurately high price-to-book ratio -- which is why you can't rely on this measure in all industries.
Every Car Still Needs Good Brakes
Regardless of your company's industry, you still should look at the price-to-book ratio because itwill give you a good feel for how your stock is trading against the rest of the market. In addition, it's a pretty stable number over time, since you're working with hard assets, says Matt McGrath, senior vice president at the financial planning house of Evensky & Katz in Coral Gables, Fla. The value of those assets doesn't change on the books with changing market conditions.
You can't say that about the ubiquitous price-to-earnings ratio. That baby varies since earnings are strongly affected by different sets of accounting rules.
So, a good way to use the price-to-book ratio is to compare your stock to the overall market. These days, the
's price-to-book ratio is hovering around 2.5 to 3.
Where does your company fall? If its price-to-book is lower, it might be a good
value play. If it's higher, it could be more of a growth stock that the market is willing to put a premium on. Either way, use the ratio as a springboard for further investigation.
So let a company's book value and its corresponding price-to-book ratio help you test drive some stocks. Just don't let that one ratio make-or-break your decision.
Same goes for the Lamborghini. Just because the pedals are close together and your feet are too big doesn't mean you shouldn't buy.
It just means you should let me drive it because my feet are smaller.
Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;
to send her an email.