What Is Price-To-Book Ratio?
The Price-to-book ratio compares the market capitalization or total value of outstanding shares of a particular company to its book value. This ratio helps investors decide whether the investment in a company will meet their investment objectives. It requires understanding two key terms- market value and book value.
Market Value:
Market value is the current market capitalization of the company calculated by the current share price of the company, along with the number of outstanding shares.
Market capitalization= Price of a share x No. of shares outstanding
Book Value:
Book value per share (BVPS) counts the amount that remains with the company if it shuts down and pays all its liabilities. This number gives investors the net value of the company's assets.
Book >
All these elements can be found in the balance sheet of the company.
Formula And Calculation of PB Ratio
A company's Price-To-Book Ratio is determined by dividing its stock price per share by its BVPS.
The Price-To-Book Ratio formula is:
Market Price Per Share/Book Value Per Share
Let's find out how we can calculate the Price-To-Book Ratio for JOE company. Let's say their market price per share is Rs. 95, and their outstanding shares are 1000. According to the balance sheet, their total assets come out to be Rs. 520,000, and their total liabilities are Rs. 410,000. Then, their net value of assets is 520,000-410,000= Rs. 110,000. The book value per share price would be 110,000/1000= Rs. 110.
Hence, the Price-to-book ratio for JOE trades is 95/110= 0.86
Interpretation Of the PB Ratio
For investors, the PB ratio is crucial to seek undervalued stocks that they can buy with the expectation of a market value rise so they can sell their shares at a profit in the future.
A conventional rule of thumb states that a low-rate stock has a PB ratio below 1.0. Any value below 3.0 but above 1.0 is seen as a decent PB ratio by some value investors and financial professionals. The criteria for "excellent PB value" fluctuate amongst businesses, though. For the IT sector, for instance, a PB ratio below 1.0 may indicate an undervalued company, but it can be seen as detrimental to the oil and gas sector.
A low PB ratio may also indicate that the company has structural issues that are preventing it from generating profits. To determine if the stock is inexpensive or a sign of the company's troubles, the investor must consider other measures besides a review of the company's prior performance.
PB Ratio vs. Return On Equity
The ratio of an organization's equity to net income is known as return on equity. (ROE= Equity/net income) Since a company's equity is equal to the difference between its total assets and total liabilities, it is also known as Return on Net Assets.
It offers investors insight into a company's growth prospects in conjunction with the P/B ratio. Value investors typically prefer it when a company's ROE increases along with its profit-to-book ratio value.
Investors should be alert if a company's ROE significantly differs from its P/B ratio. A discrepancy between a high profit-to-book ratio and a low ROE typically indicates that a company is overvalued.
However, neither the price-to-book ratio nor the ROE should be examined independently; instead, they should be a component of a bigger and more in-depth stock study. Therefore, before deciding whether a stock is worth investing in, investors need to properly consider other factors.
Uses Of The PB Ratio
The P/B ratio is a popular tool for finding inexpensive stocks. The P/B ratio illustrates the value that the market places on a company's stock in relation to the equity's book value. By investing in an undervalued stock, investors are hoping to profit when the market recognizes the worth of the business and raises its price to reflect the investor's judgment.
However, when you look at the data used to calculate the P/B ratio, the factors used are the price investors are willing to pay right now, the number of shares issued by a company, and values from a balance sheet that reflect data from the past. Some investors believe the P/B ratio is a forward-looking metric reflecting a company's future cash flows. As a result, the ratio is not predictive of or an indicator of future cash flows.
For investors looking for growth at a fair price, the P/B ratio offers a useful reality check. Return on equity (ROE), a reliable growth measure, is frequently used to assess it. Investors often become alarmed when there are significant differences between the P/B ratio and ROE.
Limitations Of The PB Ratio
- The first thing that should be mentioned as a limitation of the PB ratio is that the meaning and application of the Profit-to-Book ratio differ from industry to industry. No one number can be used across businesses and industries. Hence standard metrics must exist to enable comparison using the P/B ratio.
- The PB ratio has limitations for businesses with a large percentage of intangible assets. Consider businesses whose main assets are their original ideas, patents, or brand recognition. Such businesses' most valuable assets are intangible and will not be included in their balance sheet. This naturally results in a false view of the company's value and its PB ratio.
- Another significant limitation of the PB ratio is that the book value only takes into account the asset's original purchase price (for example, the cost of equipment) and not its current market worth. The accuracy of the value can suffer because of this.
Conclusion
Since, with a PB ratio of less than 1.0, the accounting value of the company's assets, if sold, would be higher than the market price of the shares, it is assumed that the market is underpricing the stock. In conclusion, the price-to-book ratio, meaning, a company's stock price in relation to its assets' book value, helps value investors seek out businesses with low price-to-book ratios, among other criteria.