With so many companies listed on the financial markets, it can be exciting and challenging at the same time to determine which company to invest. Thankfully, an investor needn’t always have to trust their instinct to invest but can go about it systematically. They can factor in specific ratios such as ‘return on net worth’, ‘earnings per share’, ‘return on invested capital’, or the ‘price-to-book ratio’ amongst others that can help determine the value of the company’s stock.
Here, we will discuss the price-to-book ratio, also known as the PB ratio, P/B ratio, or market-to-book ratio.
What is PB ratio in stock market?
The PB ratio helps the investor compare the market value of a particular company’s shares/ market capitalization to its book value.
Understanding the price to book ratio meaning involves understanding the meaning of two related terms- market value and book value.
Market value refers to the company’s market capitalization. It is based on the current share price multiplied by shares outstanding.
The book value refers to the amount the shareholders would receive if the company were to shut down immediately, liquidate, and pay off all its liabilities. The amount that remains is the book value. The book value is calculated by subtracting the company’s total liabilities from its total assets. This value can be found in the company’s balance sheet. Intangible assets such as patents, customer lists, copyrights, brand recognition, and goodwill are not included in the balance sheet.
Calculating the PB ratio:
The formula to calculate the PB ratio is the market price per share/ book value per share.
Let’s see an example of how the PB ratio is calculated. Company ABC has listed Rs. 10,00,000 worth of assets, and Rs. 7,50,000 as its liabilities in the balance sheet. The book value of the company can be calculated as 1000000-750000= 250000. If there are 10,000 outstanding shares of the company, the book value per share is Rs. 25. If the market price of a stock is Rs. 30, then the PB ratio is 1.2.
Uses of the PB ratio:
The PB ratio is essential for value investors- investors looking to purchase undervalued stock with the presumption that in the future, the market value of the stock will rise and they can sell off their shares at a profit.
Conventionally, a PB ratio of below 1.0, is considered indicative of an undervalued stock. Some value investors and financial analysts also consider any value under 3.0 as a good PB ratio. However, the standard for “good PB value” varies across industries. For example, a PB ratio of below 1.0 could be considered as indicative of undervalued stock in the IT industry. In contrast, it could be regarded as negative for the oil and gas industry.
A low PB ratio could also mean that there are foundational problems with the company because of which it is not showing earnings. The investor needs to look at other metrics along with an analysis of the company’s past work to gauge whether the stock is undervalued or indicative of the company’s problems.
Limitations of using the PB ratio:
One of the significant factors that determine the PB ratio of any company is the declared value of assets in its balance sheet. This metric is quite suitable for companies that have a considerable number of fixed tangible assets. Companies such as manufacturing firms that have machines, factories, equipment, or banking and finance institutes that have financial assets will have a book value that is more accurately reflective of its true value.
However, there is a limitation to the use of the PB ratio for companies that possess mainly intangible assets. Think about companies whose fundamental assets are its idea innovation, patents, or brand awareness. Such companies will not have their biggest assets- intangible assets- accounted for in their balance sheet. This inherently leads to a misleading perception of the company’s worth, and as a result, of its PB ratio.
Another significant limitation is that the book value considers only the original purchase price of the asset (such as equipment) and not the current market price. This could reduce the accuracy of the value.
There are other limitations- if the company made any recent write-offs, acquisitions, or share buybacks, then the book value can be distorted.
Determining the PB ratio of the company will not give you a holistic picture of the possible profitability of investing in that company. Calculate other metrics, such as return-on-equity to get more insight into the company’s potential earnings.
If you feel unsure, contact a brokerage firm to understand your investment options better and to take the right step in the direction of financial freedom.