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Price to Book Ratio or P/B Ratio is used to determine the valuation of the company with respect to its balance sheet strength. It is calculated by one of the following two methods:
1. Price/Book Value = Total Market Capitalization / Total Book Value
OR,
2. Price/Book Value = Latest Closing Stock Price / Book Value Per Share (as of the latest quarter)
Either calculation will yield the same result.
What Does Price to Book Ratio Mean
As you recall, the book value of a company is essentially the Total Shareholder Equity line in the balance sheet. Price to Book Value Ratio therefore indicates the multiple that the market is willing to pay for the accumulated Equity in the company.
The book value of a company is equivalent to the Net Worth calculation as Book Value = Assets – Liabilities. Therefore price/book ratio is an indicator of the investor interest in paying up for the companies equity.
What is a Good Price to Book Ratio
This value varies by industry. In general, the industries that depend heavily on capital equipment and inventory, such as manufacturing, commodities processing, etc, will have much of their market value determined by the amount of assets in the business. Therefore, the Price/Book Ratio for these industries will be lower.
Read more: definition of stock market
On the other hand, for industries that depend less on assets to generate revenue, for example service industries where employee skills may be the primary revenue generator, the Price/ Book Ratio will be high. One way to think of this is that for “asset light” industries, the market price of the stock depends more on other attributes of the business and less on the physical assets.
As we think about this, please remember that the liabilities are netted out of the asset value as liabilities indicate claims on the assets and therefore the entire asset is not available to the shareholders.
See also: how to calculate net profit margin
Finding Value Stocks: Low Price to Book Ratio Filters
One of the rules of thumb to find value stocks is to look for stocks with the P/B ratio of under 1. This means you can purchase the stock (or the business) for less than its net worth. This is a good benchmark to start with, but should be examined further to establish the correct valuation.
The reasons are many, but the primary reason is that the assets are not always valued correctly on the books. For example, the correct market value of the equipment or inventory or the property may be different than the company may be recording based on the standardized depreciation schedules. In some cases, equipment or property may be fully depreciated and therefore recorded as 0 on the books, but may still be in operation and be worth a good amount in the market.
As value investors, it is our job to review the assets of the company and come to our own independent judgement of the book value.
See also: what are value stocks
Other Reasons Why Book Value and Stock Price may Diverge
Consider businesses that are highly dependent on employee skills. For example, a drug company or a semiconductor chip manufacturer,
A large amount of value in these businesses is stored in the intellectual property of the company – for example, the R&D budget, the patent portfolio, etc. These assets tend to be intangibles and therefore may not be reflected on the books. In these situations, a diligent value investor would try and estimate the value of these assets to adjust the book value as reported on the balance sheet.
For more important critical ratios, check out our list of financial ratios