What is Price-to-Book Ratio?
Price-to-book ratio is a valuation multiple depicting the market’s perception of a particular stock. It evaluates the market value of the stock (or per share) in comparison to its book value. It can also be termed as the market-to-book ratio or P/B ratio.
In other words, this ratio can also be interpreted as the company’s net assets compared to the sale price of the stock.
The formula to calculate P/B Ratio is as follows:
P/B Ratio = Market Value of the share / Book Value of the share
Market Capitalization / Total Book Value
P/B ratio under 1.0 is considered the ideal ratio because the share is undervalued and a good option to purchase. The ideal ratio, however, keeps changing from one industry to another.
- Price-to-book ratio is an important financial metric used to compare a company’s market share price to the book value of its share.
- P/B ratios less than 1.0 are considered suitable for investments.
- Generally, the market value of the share is higher than the book value of the share.
- It is advisable to compare companies of the same country using the P/B ratio.
Frequently Asked Questions (FAQs)
- Is it right to invest in stocks using the P/B ratio? What are its limitations?
A low P/B ratio interprets that the stock is likely to be a good investment as it has the potential to grow. However, one should analyze other factors, like the company's balance sheet, nature of the business, etc., before making an informed decision. For instance:
- If the companies’ assets are majorly the employees, making an investment decision using the P/B ratio is irrelevant. Employees are not a part of the balance sheet shown on the asset side; however, they are shown as an expense in the company’s income statement.
- Companies with depreciating assets, like plants and machinery, face an issue while getting the same value as stated in the book.
- If the company has high debt, it is more likely that the P/B ratio will be less than 1.
- The accounting standards vary for different countries, making the P/B ratio incomparable for two or more companies.
- The book values for companies like Apple, Amazon, Microsoft, etc., become irrelevant as their intangible assets, like internal goodwill, intellectual capital, etc., are more valuable when compared to the assets in their balance sheets.
- Companies can change the book value by initiating share buybacks, increase or decrease the cash reserves, etc., without making any changes in their operations. Therefore, the P/B ratio can also lead to false interpretation.
To confirm the credibility of the P/B ratio, one should also consider other parameters before investing. Investors could gauge future company projects, study its cash flows, evaluate other financial ratios like debt-to-equity, product’s shelf life, etc.
- What are the advantages of the P/B Ratio?
Some of the advantages of using the P/B ratio are:
- It is more stable when compared to earnings. It becomes more valuable when the EPS or earnings are volatile.
- It is more relevant in comparison if the company is going out of business.
- It gives an understandable picture of the company’s market valuation in comparison to its net worth.
- Which ratio is more relevant in analyzing the company's financial performance, P/E ratio or P/B ratio?
When comparing if the P/B ratio is better than the P/E ratio, the answer mainly depends on the industry in the question. For instance:
- For Banks: The earnings for banks can fluctuate in large variations in every quarter, making the P/E ratio less reliable. However, the P/B ratio is suitable to value a bank’s stocks.
- For Asset-Light Companies: Companies in the information technology industry have more intangible assets, like intellectual property, internal goodwill, etc., making the P/B ratio less favorable.
To obtain an accurate picture of the company’s health and financial performance, we might use both ratios. The application of ratios ultimately depends on the industry we are dealing with.
- What does a P/B ratio less than 1 indicate to investors?
The P/B ratio is a reliable metric to identify the undervalued stocks in the market. If the P/B ratio is less than one, it denotes one of the two things to the investors:
- Overstated Asset Value: If the market thinks that the value of the assets is overstated, investors are recommended to stay away from such stocks. There is a possibility that the market can correct asset valuations, leading to negative returns to the investors.
- Negative Return on Assets: If a company is earning negative returns on its assets, there is a possibility that the business could take up a new shape, or the management will come up with a prompt solution and give positive returns to the investors or its shareholders.
Therefore, it is highly advisable not to rely on just one metric to evaluate a company’s financial performance and health.
- What are the other ratios to use other than the P/B ratio and P/E ratio in stock valuation?
To study the share price with the company’s earnings, the following ratios can also be used to calculate if a stock is expensive or cheap.
- Price-to-earnings-to-growth ratio (P/EG Ratio): A company’s profits are related to its growth. There are instances when the share price increases at a faster rate than the company’s profit, leading to mispricing. To overcome this, stakeholders use the P/EG ratio. It is determined by dividing the P/E ratio by the company’s expected growth. A P/EG ratio less than 1 indicates that the company’s stock is undervalued.
- Price-to-cash flow ratio (P/CF Ratio): Due to inconsistent accounting practices, increasing non-cash transactions, etc., investors prefer to consider the cash flows to evaluate the company’s profitability or stock’s price. It is calculated by comparing the market share price with the operating cash flow per share of the company in a fiscal year. Investors often prefer the P/CF ratio over the P/E ratio because earnings can be easily manipulated in comparison to the cash flows.