Investors use several metrics to determine whether purchasing stocks of a company will suffice their investment objectives or not. One 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.
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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.
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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 –
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P/B Ratio = Market Capitalisation / Book Value of Assets |
Alternatively, investors can derive the Price to Book Ratio formula as expressed below –
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P/B Ratio = Market Price Per Share / Book Value of Assets Per Share |
Let’s consider an example.
Let's say 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.
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Particulars |
Amount (Rs.) |
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Assets |
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Current Assets |
|
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Cash and Cash equivalents |
25000 |
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Accounts receivable |
45000 |
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Fixed Assets |
|
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Machinery |
2,00,000 |
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Property, Plant, and Equipment |
2,50,000 |
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Total Assets |
5,20,000 |
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Liabilities |
|
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Current Liabilities |
|
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Accounts payable |
20,000 |
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Outstanding expenses |
30,000 |
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Non-current Liabilities |
|
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Long-term debts |
3,00,000 |
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Other non-current liabilities |
60,000 |
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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. 1,10,000
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. (1,10,000/1000) = Rs. 110
Therefore, P/B ratio = 95/110 = 0.86
As mentioned previously, the Price-to-book ratio is utilized 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 analyzing the P/B ratio of any company. It is that market capitalization 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.
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 realize 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.