The price-to-book ratio, or P/B ratio, is one of several metrics that help analysts and investors evaluate a company’s value. This specific measure compares a company’s stock price to its book value. P/B ratios compare the company’s market capitalization with its book value, indicating whether a stock is trading under or over market value.
Generally, a lower P/B ratio is better, but lower values are not always a good thing. According to Forbes, investors often analyze P/B ratios in value investing.
Continue reading to learn about the P/B ratio and how analysts utilize it to assess a company’s value.
How To Calculate the P/B Ratio
The P/B ratio is an essential metric for investors to understand the value of a company. To calculate a P/B ratio, divide a given company’s stock price per share by its book value per share. To calculate its book value per share, take the book value and divide it by the total number of outstanding shares.
Take an imaginary company’s stock as an example. Assume the company has a market cap of $1 billion, and its stock is currently trading at $10.
This hypothetical company has $100 million in assets and $50 million in liabilities on its balance sheet. Therefore, the book value of this company is $50 million. If this company had 10 million outstanding shares, its book value per share would be $5.
The P/B Ratio Formula
Using the P/B ratio formula, divide the market price per share by the book price per share. The P/B ratio for this imaginary company equals 2. In other words, the stock is trading at twice its book value.
Lower P/B ratios can identify undervalued or cheap stocks. According to Forbes, any value below 1.0 indicates a potential bargain. Yet some growth companies can trade at multiples of their book value, so it depends on what sector you’re evaluating.
Conversely, as a stock’s market price increases, so too does its price to book ratio. For example, Zoom’s net worth climbed in 2020 as the business world shifted to remote work and virtual conferencing. As its share price increased, so did its P/B ratio.
What Is Book Value?
One way to think about book value is, essentially, as the net asset value of a company if it were to be liquidated. It’s calculated by subtracting a firm’s intangible assets and liabilities from its total assets. In other words, it’s the value the company would have on a balance sheet.
Keep in Mind
A low P/B ratio may also be a warning sign of other problems in a firm. Recall that the P/B ratio goes down as the stock price declines. Thus, for a company whose stock price is in decline due to problems of some kind, the P/B ratio will also decline.
Always Consult Other Valuation Measures
Note that the P/B ratio only refers to a firm’s stock price compared with its book value. This metric doesn’t consider other factors like sales or profits. It’s certainly not advisable to assess the value of a company based on its P/B ratio alone. This ratio is just one of many important valuation metrics that analysts and investors should research.
There are other important ways to research stocks as well:
- Price to Sales
- Price to Earnings
- Price to Cash Flow
The P/B ratio is helpful, but it shouldn’t be the only metric for determining whether to invest in a company.
Frequently Asked Questions
How are P/B ratios helpful?
A price to book ratio is a useful measure that value investors calculate to identify potentially undervalued stocks. The metric indicates the worth that investors place on a company’s equity relative to its book value.
A company with a higher net book value demonstrates a robust financial position for its investors. It’s a straightforward filter that some investors use to screen investment opportunities.
What is a good P/B ratio?
Like most valuation measures, there isn’t a single answer for what constitutes a “good” numeric value. While lower P/B ratios are generally better, it’s essential to use the metric as a relative comparison with other companies of the same size and in the same sector.
For a company with a high P/B ratio, you’ll want to investigate its financials further to determine whether that valuation makes sense.
What are the limitations of the P/B ratio?
The price to book ratio takes book value into account, entailing that it can suffer from the impact of large and sudden expenses. This can happen because of accounting practices that require companies to realize those expenses immediately.
One example of this is the expense of research and development efforts. R&D expenses affect a company’s book value, even though its investors may value such R&D efforts as a potential book for the company in the future. Forbes rightly points out that context determines whether intangible assets are a hidden value or a value killer in any business.
Book values can be negative when a company has a series of negative earnings. Here, the metric becomes nearly useless for comparing the value of similar firms.
Comparing the P/B ratios of vastly different-sized companies or companies in disparate industries is a waste of time. To get the most out of this relative comparison, you should compare companies with similar market capitalizations within the same industry.
What is the difference between the P/B and P/E ratios?
The P/B ratio measures a company’s intrinsic value based on its book value. It takes assets, liabilities and intangible assets into account. The price-to-earnings ratio, on the other hand, measures a company’s worth based on its profits.
Both ratios can help investors measure a company’s value. It’s essential to compare P/B ratios between similar-sized companies in the same industry.
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