Investors use several metrics to determine whether purchasing stocks of a company will suffice their investment objectives or not. One of such metric is the Price-to-book value ratio, also known as a price-equity ratio.
It represents the relationship between the total value of an organisation’s outstanding shares and the book value of its equity.
In essence, the P/B ratio draws a relationship between the market capitalisation of an organisation and the value of assets it possesses.
In some cases, the two components are boiled down to a per-share value. In this case, the total value of outstanding shares is divided by the number of outstanding shares of an organisation. Similarly, a company’s net value of all its assets is divided by the number of its shares trading in the market.
Value investors typically use the P/B ratio, amongst other metrics, to determine whether a company’s stocks are overvalued or undervalued. Value investing involves investors ferreting out those companies’ stocks that trade below their intrinsic value. In that regard, a P/B value comes forth as a critical agency.
As mentioned earlier, the price to book ratio determines the relationship between the total value of a company’s outstanding shares and the net value of its assets, as reflected in the Balance Sheet.
Therefore, first, investors need to find the product of the current market price of a company’s stocks and the total number of outstanding shares, which is its market capitalisation.
Market capitalisation = Market value of a stock x Number of outstanding shares
Secondly, investors need to determine the net value of an organisation’s assets. To do so, they need to add up the book values of all the assets present in a company’s balance sheet and deduct the total value of all debts and liabilities.
Book value of assets = Total assets – total liabilities
In a roundabout way, this value represents the equity value of an organisation.
Nevertheless, the price to book value formula is expressed below –
P/B ratio = Market capitalisation / Book value of assets
Alternatively, investors can derive this ratio as expressed below –
P/B ratio = Market price per share / Book value of assets per share
Let’s consider an example.
Example: The stocks of Company JOE trades at a market value of Rs.95/share. The number of outstanding shares is 1000. Its list of assets and liabilities is mentioned in the table below.
Particulars | Amount (Rs.) |
Assets | |
Current Assets | |
Cash and Cash equivalents | 25000 |
Accounts receivable | 45000 |
Fixed Assets | |
Machinery | 2,00,000 |
Property, Plant, and Equipment | 2,50,000 |
Total Assets | 5,20,000 |
Liabilities | |
Current Liabilities | |
Accounts payable | 20,000 |
Outstanding expenses | 30,000 |
Non-current Liabilities | |
Long-term debts | 3,00,000 |
Other non-current liabilities | 60,000 |
Total liabilities | 4,10,000 |
Thereby, the net value of assets of Company JOE will be:
Net value of assets = Rs. (520,000 – 410,000) = Rs. 90,000
Since the number of outstanding shares of this company is 1000, the price per book value will be:
Book value of assets per share = Rs. (90000/1000) = Rs. 90
Therefore, P/B ratio = 95/90 = 1.05
As mentioned previously, the Price-to-book ratio is utilised by value investors to ferret out company stocks that are undervalued. It portrays the relationship between what the market perceives the value of a company’s equity to be and the actual book value of its equity. It is, thus, a considerable agency for value investing.
However, investors must note an important factor before analysing the P/B ratio of any company. It is that market capitalisation is future-looking as it reflects the current perception of a company’s equity value. On the other hand, the book value of assets and liabilities might be subject to historical costing and therefore, may be inflated.
A “good” P/B ratio
Nevertheless, typically the market value of a company is higher than its book value and therefore, results in a ratio higher than 1. However, the converse can also be true.
This particular phenomenon can be interpreted in a couple of ways – a company is suffering through financial duress or the market considers an overstated asset value. In the former case, value investors can bet that it can realise a turnaround with changes in its business conditions. However, if the latter is true and all probabilities indicate a further decline in the value of assets, it comes forth as a negative projection.
Typically, value investors consider a Profit-to-book value ratio below 1 to be an indicator of an undervalued stock. However, a P/B ratio of 3 is widely regarded as a standard for undervalued stocks.
Nevertheless, it shall be noted that the significance and interpretation of the Profit-to-book ratio vary from one industry to another. No single value can be applied across companies and industries and shall possess common parameters to facilitate a comparison through the P/B ratio.
For instance, tech-intensive companies will have assets that cannot be valued like Intellectual Property and therefore, its book value of assets might be low. On the other hand, tangible asset-intensive companies will possess a high net book value of assets. Therefore, the comparison between such companies based on the Price-to-book value ratio will compromise the analysis.
As a result, some investors also employ another metric in conjunction with a P/B ratio to determine whether a company is undervalued or overvalued.
Return on Equity is the ratio between an organisation’s equity and net income. It can also be called Return on net assets since a company’s equity is equal to the difference between its total assets and total liabilities.
In conjunction with the P/B ratio, it provides the investor insight into a company’s growth prospects. Typically, it is favoured by value investors that an organisation’s ROE grows in tandem with its profit-to-book value ratio.
In case, a company’s ROE is wildly discrepant with its P/B ratio, it indicates a red flag for investors. Also, in most cases, a high profit-to-book ratio and a low ROE imply that a company is overvalued.
Regardless, both price-to-book ratio and ROE should be part of a larger and more thorough analysis of stocks and should not be carried out in isolation. Therefore, investors should duly consider other parameters before determining whether a stock is worth investing or not.