Market-book ratios equals to Market price per stock divided by Book value per stock. Book value represent history cost that shareholders has paid, yet market price represent the comprehensive evaluation on operation. When Market-book ratios higher than 1, it means market price per stock is higher than book value per stock, so the assessment firm get is positive. As Ben McClure (2013) points out, when market-book ratios less than 1, it means market think the asset value is overstated or company’s return on its assets are really very poor.
Suppose the market-book ratios of ABC tend to cluster around 1.02 in year 9,
PV(horizon value)=1/(1.1)^9 (1.02×21.21)=9.18
But this approach have 2 shortcomings. First is book value ignore the inflation. Inflation is one of the reason that book value is different with market price, if it’s in the rapid inflation, the book value will higher than the actual value, it makes market-book ratios lower and the horizon value fall far behind actual asset values.
Second, book value didn’t calculate the intangible assets, such as patents and brand name. Especially for some software company like Microsoft, whose most asset value are intellectual property, and its market price almost less than 10 times book value (Ben McClure 2013).
It’s easier to value a mature business rather than start-up business. Start-up business are lack of long FCF, in most cases, data based on the assumption and you hardly find a sample of truly similar company as comparable, so the result maybe little more subjective.
Even though market-book ratios have shortcomings, but it’s still an easy tool to close to actual value of business. For this reason, investors should give attention to the relationship between market price and book value.