The price-to-book ratio (P/B ratio) measures the value that the stock market places on a company relative to its book value. The P/B ratio is also sometimes referred to as the price-equity ratio and is often used by investors looking to find undervalued companies; that is, companies that look cheap at their current market price.
What is book value?
Book value is short for book value of equity and is sometimes known as net asset value (NAV). Book value relates to the company’s value according to its balance sheet, and represents common stock shareholder equity (plus reserves and less any intangible assets on the balance sheet such as goodwill). It is thus an estimate of the liquidation value of a company. Book value is calculated as follows:
\(\mathrm{Book \:value}={\mathrm{total\: assets\: –\:liabilities\: + intangible \:assets}}\)
In order to calculate the P/B ratio however, it is necessary to know the book value per share of the company. This can be calculated by dividing the book value by the number of common shares outstanding.
Calculating the P/B ratio
The value that is placed on a company by the stock market is quite simply the company’s current share price, so the P/B ratio is:
\(\mathrm{Price-to-book}=\frac{current\: share\: price
}{book \:value \:per\: share}\)
For example, Company F has total assets of €63,522 on its balance sheet and liabilities and intangible assets of €50,178. There are currently 8,000 Company F shares outstanding and the market price for one share is €3.24.
Company F’s book value per share is:
\(\frac{€\:63,522\:-\:€\:50,178}{8,000} \:\:\:\:\:= {\mathrm{€\:1.67\:,\:therefore\: the\: company’s \:P/B\: ratio \:is}}\frac{3.24}{1.68}={\mathrm{1.9}}\)
Interpretation of results
Although the P/B ratio is considered by many to be relatively simplistic, it does provide a quick overview as to the value of a company. During bull markets, it is not uncommon to see market values far exceeding book values, and therefore high P/B ratios, but during bear markets it is more likely that the two values will be similar, and the P/B ratio will therefore be nearer to 1.
If a company has a high P/B ratio, this could mean that it is overvalued. However, if the share price is higher than the book price, this could also indicate that market predictions for the company’s future are good and earning potential is high.
Value investors, such as Warren Buffet, tend to look for companies with a P/B of less than 1, as this could mean that the stock is undervalued and therefore has a potential profit in it. However, there might also be good reason for the company to have a low standing in the market, such as poor outlook. Moreover, consumer and service orientated companies will frequently have negative P/B ratios. This does not necessarily mean that they have growth potential; it might just be that the company has relatively more liabilities than assets.
The P/B ratio should therefore be used in conjunction with other analytical tools and financial measurements, such as the return on equity, in order to provide a complete picture. Cash flow and volatility of earnings are also important elements to consider.
