What Is the Price-to-Book(P/B) Ratio?
Many investors use the price-to-book ratio (P/B ratio) to compare a firm's market capitalization to its book value and locate undervalued companies. This ratio is calculated by dividing the company's current stock price per share by its book value per share (BVPS).
Key Takeaways
- The price-to-book (P/B) ratio measures the market's valuation of a company relative to its book value.
- The market value of equity is typically higher than the book value of a company's stock.
- The price-to-book ratio is used by value investors to identify potential investments.
- P/B ratios under 1.0 are typically considered solid investments by value investors.
- A good P/B ratio is relative to a business and its industry.
:max_bytes(150000):strip_icc()/price-to-book-ratio-bf64b6abed4d4d2292f3ab58bd55ed36.png "Price-to-Book (P/B) Ratio: Meaning, Formula, and Example (1)")
Formula and Calculation of the Price-to-Book(P/B) Ratio
The formula for the price-to-book ratio is:
P/BRatio=BookValueperShareMarketPriceperShare
Where:
- Market Price per Share = Current market price of the share
- Book Value per Share = (Total assets - intangible assets - total liabilities) ÷ number of outstanding shares
Market value per share is obtained by looking at the information available on most stock tracking websites. You need to find the company's balance sheet to obtain total assets, total liabilities, and outstanding shares. Most investment websites display this financial report under a "financials" tab—some show it on a stock's summary tab.
What the Price-to-Book (P/B) Ratio Can Tell You
The P/B ratio reflects the value that market participants attach to a company's equity relative to the book value of its equity. Many investors use the P/B ratio to find undervalued stocks. By purchasing an undervalued stock, they hope to be rewarded when the market realizes the stock is undervalued and returns its price to where it should be—according to the investor's analysis.
Some investors believe that the P/B ratio is a forward-looking metric that reflects a company's future cash flows.
However, when you look at the information used to calculate the P/B ratio, the factors used are the price investors are willing to pay currently, the number of shares issued by a company, and values from a balance sheet that reflect data from the past. Thus, the ratio isn't forward-looking and doesn't predict or indicate future cash flows.
The P/B ratio also provides a valuable reality check for investors seekinggrowth at a reasonable price. It is often evaluated withreturn on equity (ROE), a reliable growth indicator. Large discrepancies between the P/B ratio and ROE often raise ared flag for investors.
Overvaluedgrowth stocks frequently show a combination of low ROE and high P/B ratios. Properly valued stocks have ROE and P/B ratios that grow somewhat similarly because stocks that generate higher returns tend to attract investors and increase demand, thus increasing the stock's market price.
A high P/B ratio suggests a stock could be overvalued, while a lower P/B ratio could mean the stock isundervalued.
As with most ratios, the P/B ratio varies by industry. A company should be compared with similarly structured companies in similar industries; otherwise, the comparison results could be misleading.
P/B Ratios and Public Companies
It is difficult to pinpoint a specific numeric value of a "good"price-to-book (P/B) ratiowhen determining if a stock isundervaluedand therefore, a good investment.
It's helpful to identify some general parameters or a range for P/B value, then consider various other factors andvaluationmeasures that more accurately interpret the P/B value and forecast a company's potential for growth.
The P/B ratiohas been favored byvalue investorsfor decades and is widely used by marketanalysts. Traditionally, any value under 1.0 is considered desirable for value investors, indicating an undervalued stock may have been identified. However, some value investors may often consider stocks with a less stringent P/B value of less than 3.0 as their benchmark.
Equity Market Value vs. Book Value
Due to accounting procedures, the market value of equity is typically higher than a security's book value, resulting in a P/B ratio above 1.0. During times of low earnings, a company's P/B ratio can dive below a value of 1.0.
For example, in most cases, companies must expenseresearch and developmentcosts,reducing book value because this includes the expenses on the balance sheet. However, these R&D outlays can create unique production processes for a company or result in new patents that can bring royalty revenues.
While accounting principles favor a conservative approach in capitalizing costs, market participants may raise the stock price because of such R&D efforts, resulting in wide differences between the market and book values of equity.
Example of How to Use the Price-to-Book(P/B) Ratio
Assume that a company has $100 million in assets on the balance sheet, no intangibles, and $75 million in liabilities. Therefore, the book value of that company would be calculated as $25 million ($100 million - $75 million).
If there are 10 millionshares outstanding, each share would represent $2.50 of book value. Therefore, if the share price is $5, the P/B ratio would be 2.0 (5 / 2.50).
This illustrates that the market price is valued at twice its book value, which may or may not indicate overvaluation. This would depend on how P/B ratios compare against other similarly sized companies in the same sector.
The price-to-book ratio may not be as useful when evaluating the stock of a company with fewer tangible assets on its balance sheets, such as services firms and software development companies.
Price-to-Book(P/B) Ratio vs. Price-to-Tangible-Book Ratio
Closely related to the P/B ratio is the price-to-tangible-book value ratio (PTVB). The latter is a valuation ratio expressing the price of a security compared to its hard (or tangible) book value as reported in the company's balance sheet. The tangible book value number is equal to the company's total book value less than the value of any intangible assets.
Intangible assets can be items such as patents, intellectual property, and goodwill. This may be a more useful valuation measure when valuing something like a patent in different ways or if it is difficult to put a value on such an intangible asset in the first place.
Limitations of Using the Price-to-Book(P/B) Ratio
Investors find the P/B ratio useful because the book value of equity provides a relatively stable and intuitive metricthey caneasily compareto the market price.
The P/B ratio can also be used for firms with positive book values and negative earnings since negative earnings render price-to-earnings ratios useless. There are fewer companies with negative book values than companies with negative earnings.
However, when accounting standards applied by firms vary, P/B ratios may not be comparable, especially for companies from different countries.
Additionally, P/B ratios can be less useful for serviceand information technology companies with little tangible assets on their balance sheets. Finally, the book value can become negative because of a long series of negative earnings, making the P/B ratio useless for relative valuation.
Other potential problems in using the P/B ratio stem from the fact that any number of scenarios, such as recent acquisitions, recent write-offs, or sharebuybacks can distort the book value figure in the equation. When searching for undervalued stocks, investors should consider multiple valuation measures to complement the P/B ratio.
What Does the Price-to-Book (P/B) Ratio Compare?
The price-to-book ratio is a commonly used financial ratio. It compares a share's market price to its book value, essentially showing the value given by the market for each dollar of the company’s net worth.
High-growth companies often show price-to-book ratios well above 1.0, whereas companies facing financial distress occasionally show ratios below 1.0. Another valuable tool is the price-to-sales ratio, which shows the company's revenue generated from equity investments.
Why Is the Price-to-Book (P/B) Ratio Important?
The price-to-book ratio is important because it can help investors understand whether a company's market price seems reasonable compared to its balance sheet. For example, if a company shows a high price-to-book ratio, investors might check to see whether that valuation is justified given other measures, such as its historical return on assets or growth in earnings per share (EPS).
What Is a Good Price-to-Book (P/B) Ratio?
What counts as a “good” price-to-book ratio will depend on the industry in question and the overall state of valuations in the market. An investor assessing the price-to-book ratio of a stock might choose to accept a higher average price-to-book ratio, as compared to an investor looking at the stock of a company in an industry where lower price-to-book ratios are the norm.
The Bottom Line
The price-to-book (P/B) ratio considers how a stock is priced relative to the book value of its assets. If the P/B is under 1.0, then the market is thought to be underpricing the stock since the accounting value of its assets, if sold, would be greater than the market price of the shares.
Therefore, value investors typically look for companies that have low price-to-book ratios, among other metrics. A high P/B ratio can also help investors identify and avoidovervaluedcompanies.
