Price to book ratio

Quick definition

Price to book (P/B) is a financial metric used to compare the value of a company’s net assets relative to the prevailing share price.

Key details

• The P/B ratio is one way to measure a company’s value
• It is calculated by dividing the market capitalization by the current equity
• A high P/B ratio indicates the share price might be overvalued

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

The P/B ratio compares a company’s market capitalization to its share price. The metric finds excellent use in the valuation of companies comprised of liquid assets. However, the metric is not useful for firms with large research and development expenditures or firms with high levels of fixed assets.

The comparison seeks to indicate the difference between the market value and book value of a company. The market value is a term used to indicate the value of all outstanding shares in the market. In other words, it is the value that the market pegs on the company. The book value on the hand is the value of a company’s net assets minus liabilities and all intangible assets.

How is a P/B ratio calculated?

The price to book ratio is calculated by dividing a company’s current market capitalization by its book equity, which you can find in the latest set of accounts.

P/B ratio = market capitalization/equity

What does the P/B ratio mean?

The market price, in this case, is the current share price that a company is trading in an open market. The book value, on the other hand, is the value of total assets minus liabilities.

A P/B of less than one indicates a company is selling at less than the value of its assets, thus the undervalued conditions. A P/B of more than one on the other hand indicates investors willing to pay more compared to what the net assets are worth. Such investments show investors a strong belief in a company’s future profit projections.

A lower P/B ratio is also at times associated with undervalued stocks. However a lower value could signal something wrong fundamentally with a company.

Value investors consider any P/B ratio below one as good value, as it indicates that a stock is undervalued. It provides an opportunity to buy a stock at a discount in anticipation that its valuation will go up.

Using P/B ratio for stock evaluation

P/B should never be used in isolation to make investment decisions. This is because while a low P/B can signal an undervalued stock, it could also occur as a result of serious underlying problems. The fact that the metric fails to factor in future earnings prospects or intangible assets makes it insufficient for making investment decisions by itself.

In addition, factors such as acquisitions, write-offs, and share buybacks can distort book value, leading to inaccuracies in determining the true price to book ratio. It is for this reason that investors are encouraged to use multiple valuation measures when trying to construct an accurate stock valuation.

Price to book ratio also acts as an ideal tool for identifying overhyped stocks in the market. It is common to find stocks in the market with a high share price backed by insignificant assets, which are crucial to generating long-term value.

When using P/B to compare companies, it is important to compare firms within the same industries, affected by similar market conditions. For instance, tech companies’ stocks tend to trade with a high P/B ratio compared to financial stocks.