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Price-to-Book Ratio (P/B Ratio) Definition
Price to book ratio is primarily used to indicate if a company is going bankrupt or not. It is also known as a price-equity ratio. The price-to-book ratio compares a company’s market value to its book value. This is calculated by dividing price per share by book value per share (BVPS). This book value refers to the total net asset value of a company. And it is calculated by total assets minus intangible assets. Intangible assets are patents, goodwill, and liabilities. Book value can also be calculated as trading costs, sales taxes, service charges, and others. For example, an asset’s book value equals its purchasing value on the balance sheet, and it is calculated by deducting any depreciation from the asset’s value.
The Formula for the P/B Ratio is:
P/B ratio=book value per share/market price per share
How to Calculate the P/B Ratio
The P/B ratio is an indicator of a company’s viability to bankruptcy or the valuing of a company’s stocks. In other words, a lower P/B ratio indicates an undervalued stock while a higher ratio states the other. It could also mean that the company is spending much on a constant asset.
In calculating the P/B ratio, the book share value and market price per share values are important. Book share value is calculated by deducting total assets from total liabilities over a number of shares outstanding while Market value per share is calculated by observing the share price quote in the market.
What Does the Price-to-Book Ratio Reveal?
As affirmed above, the price-to-book ratio compares a company’s market value to its book value. If a company monetized all its assets so as to pay its debts, whatever the company has is its book value and the market value is the share price multiplied against the number of outstanding shares.
The P/B ratio basically shows how market participants view a company’s equity in relation to its book value of equity. The book value of equity refers to the amount available for distribution to shareholders. The book value of equity shows past records of issued equity and others.
To state that a company has a good price-to-book ratio is quite difficult as this ratio differs from one industry to another. There is no specific numeric value for indicating if a stock is undervalued or a profitable investment. However, it is quite useful for investors to identify some range for P/B values and also consider some other factors to accurately interpret the P/B value so as to identify a company’s potential for growth.
For example, Value investors consider any value under 1.0 a good P/B, this indicates a potentially undervalued stock. However, value investors may often consider stocks with a P/B value under 3.0 as their benchmark.
P/B ratio is a factor to be considered for investors seeking growth at a reasonable price, it often considered with return on equity (ROE). These are often trustworthy growth indicators. Any form of discrepancies in the two such as irregular indicators between the two displays a high risk of investment in the company. A low ROE and a high P/B ratio indicates an over valued stock. If one of the other is growing the other should also grow.
The P/B ratio has been considered as the most resourceful factor for investment by value investors for a long time. It is widely used by Market Analysts.
Note that the P/B ratio can also be used to compare companies with the other and also the market’s value of a company in relation to its book value is measured. This ratio is used by value investors to identify potential risk.
Example of How to Use the P/B Ratio
For example, if a company has $100 million in assets on the balance sheet and $75 million in liabilities. The book value of that company would be calculated simply as $25 million ($100M – $75M). And peradventure, there are 10 million shares outstanding, each share would represent $2.50 of book value. If each share sells on the market at $5, then the P/B ratio would be 2x (5 ÷ 2.50). This shows that the market price is valued at twice its book value. This typically illustrates the use of the P/B ratio.
The Difference Between an Equity’s Market Value and Book Value
Accounting principles formerly do not account for brand value and other intangible assets. It does accounts for this when the company derives these assets through acquisitions. Some costs incurred by a company are treated differently due to accounting standards, this impacts the market value of equity of such company. Here, The market value of equity is higher than the book value of the company, producing a P/B ratio above 1. However, some situations such as financial incapacities, bankruptcy and others may warrant a company P/B ratio to be valued below 1.
There is also a huge difference in market value and book values of equity for example when companies cover for research and development costs. This thus reduces a company’s book value. On the other hand, these costs can result in large productions or result in patents that can bring royalty revenues forward. While accounting principles favor a conservative approach in capitalizing costs, market participants may raise the stock price because of such development.
Price-to-Book Ratio Versus Price-to-Tangible-Book Ratio
The Price to Tangible Book Value is similar to the P/B ratio. The PTBV ratio is reported in the company’s balance sheet and may be useful when the market is valuing patents and others. It estimates the price of a security in relation to its tangible book value. This value equals the companies total book value minus intangible assets. Intangible assets such as patents, intellectual property, and goodwill.
Limitations of the P/B Ratio
Though P/B ratios are useful for firms with positive book values and negative earnings since negative earnings render price-to-earnings ratios useless and also useful because the book value of equity provides a stable measure investors can compare to the market price. But, P/B ratios may not be useful when firms’ accounting standards are not the same. For example in the case of companies from different countries.
Also, recent acquisitions, write offs, share buybacks can affect the book value in a P/B equation. It can be concluded that in estimating an undervalued stocks, investors shoukd put into consideration other meausres of valuation with the P/B ratio.
Likewise, P/B ratios may be useless in the information technology industry as there are several companies with little tangible assets on their balance sheet. Lastly, the book value can become negative when there has been series of negative earnings by a company.