Price-to-Book (P/B) Ratio

What is the price-to-book (P/B) ratio?

Companies use the price-to-book ratio (P/B ratio) to compare a company’s market capitalization to its book value. It is calculated by dividing the company’s stock price by its book value per share (BVPS). An advantage book value is equal to its book value on the balance sheet, and companies calculate it by offsetting the asset by its accumulated depreciation.

Formula and calculation of the Price-to-Book (P/B) ratio

In this equation, the book value per share is calculated as follows: (total assets – total liabilities) / number of shares outstanding). The market value per share is obtained by simply looking at the price of the stock in the market.

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A lower P/E ratio could mean the stock is undervalued. However, it could also mean that something is fundamentally wrong with the business. As with most ratios, this varies by industry. The P/B ratio also indicates whether you are paying too much for what would be left over if the company went bankrupt immediately.

What the P/E ratio can tell you

The P/B ratio reflects the assess that market participants attach to a company’s equity relative to the book value of its equity. The market value of a stock is a forward-looking measure that reflects the future of a company cash flow. The book value of equity is an accounting measure based on the historical cost principle and reflects past issuances of equity, plus any profit or loss, and minus dividends and shares. redemptions.

The price-to-book ratio compares a company’s market value to its book value. The market value of a company is its share price multiplied by the number of shares outstanding. Book value is the net assets of a business.

In other words, if a company liquidated all of its assets and paid off all of its debts, the remaining value would be the book value of the company. The P/B ratio provides a valuable reality check for investors looking growth at a reasonable price and is often viewed in conjunction with return on equity (ROE), a reliable indicator of growth. Large discrepancies between the P/B ratio and the ROE often generate a red flag on businesses. Overvalued growth stocks often display a combination of low ROE and high P/E ratios. If a company’s ROE increases, its P/B ratio should also increase.

P/E ratios and public companies

It is difficult to identify a specific numerical value of a “good” price-to-book (P/B) ratio when determining whether a stock is undervalued and therefore a good investment. Ratio analysis may vary by industry. A good P/E ratio for one industry may be a bad ratio for another.

It is helpful to identify some general parameters or range of P/B values ​​and then consider various other factors and Evaluation metrics that more accurately interpret P/B value and predict a company’s growth potential.

The P/E ratio was favored by value investors for decades and is widely used by the market analysts. Traditionally, anything below 1.0 is considered a good P/B for value investors, indicating a potentially undervalued stock. However, value investors can often look to stocks with a P/B value below 3.0 as a benchmark.

Stock Market Value vs. Book Value

Due to accounting conventions on the treatment of certain costs, the Market value of equity is usually higher than a company’s book value, resulting in a P/E ratio greater than 1.0. In certain circumstances of financial difficulties, bankruptcy or expected plunges in earning powera company’s P/E ratio can dip below a value of 1.0.

Because accounting principles do not recognize intangible assets such as brand equity unless the company has obtained them through acquisitions, companies immediately recognize all costs associated with the creation of intangible assets.

For example, companies must spend research and most development costs, reducing the book value of a business. However, these R&D expenditures can create unique production processes for a company or result in new patents that can generate royalty income in the future. Although accounting principles favor a conservative approach to cost capitalization, market participants may increase the stock price due to these R&D efforts, resulting in large differences between the market and book values ​​of equity. .

Example of using the P/B ratio

Suppose a company has $100 million in balance sheet assets and $75 million in liabilities. The book value of this company would be calculated simply as $25 million ($100 million – $75 million). If there are 10 million outstanding shares, each share would represent $2.50 of book value. If the stock price is $5, the P/B ratio would be 2x (5 / 2.50). This shows that the market price is valued at twice its book value.

P/B ratio vs price/book ratio

Closely related to the P/B ratio is the price to tangible book value ratio (PTBV). The latter is a valuation ratio expressing the price of a security relative to its actual, or tangible, book value as shown on the company’s balance sheet. balance sheet. The tangible book value number is equal to the total book value of the business minus the value of any intangible assets.

Intangible assets can be things like patents, intellectual property and goodwill. This can be a more useful valuation measure when the market values ​​something like a patent in different ways or if it is difficult to assign a value to such an intangible asset in the first place.

Limitations of using the P/B ratio

Investors find the P/E ratio useful because the book value of equity provides a relatively stable and intuitive measure that they can easily compare to the market price. The P/E ratio can also be used for companies with positive book values ​​and negative earnings, because negative earnings render price/earnings ratios useless and there are fewer companies with negative book values ​​than companies having negative benefits.

However, when accounting standards applied by companies vary, P/B ratios may not be comparable, especially for companies in different countries. Additionally, P/B ratios may be less useful for service and information technology companies with little fixed assets on their balance sheets. Finally, the book value can become negative due to a long series of negative results, rendering the P/B ratio useless for Evaluation.

Other potential problems with using the P/E ratio stem from the fact that a number of scenarios, such as recent acquisitions, recent write-offs or actions redemptions can skew the book value figure in the equation. When looking for undervalued stocks, investors should consider several valuation metrics to complement the P/E ratio.