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.

In this article

**What is Price to Book Value 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.

**How is Price to Book Value Ratio Calculated?**

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

**Interpretation of P/B Value Ratio**

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.

*Limitation in interpreting Price-to-book ratio*

*Limitation in interpreting Price-to-book ratio*

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.

**P/B Ratio vis-á-vis Return on Equity**

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.