Making investments can be tricky as oftentimes stocks of a company can be overvalued. Investors must ideally seek to find undervalued companies if they hope to make a profit from these stocks. In this regard, the price-to-book ratio comes in handy as it helps identify which stocks are worth investing in. Continue reading to learn more about this ratio and the merits associated with its use.
Defining Price-to-Book Ratio
When looking at a company’s equity shares, you might find yourself wondering how the price for each of these shares is determined and whether or not it accurately captures the company’s inherent worth. The price-to-book ratio plays a key role here as it helps determine whether the price tag attached to stock is accurate or not. It also helps investors find high-growth companies that sell their stock at low-growth prices thereby making for ideal investment opportunities. Simply put, the price-to-book ratio (or P/B ratio) makes it possible to discover undervalued companies. Similarly, it helps investors pinpoint companies that are overvalued and allows them to avoid them. That being said, this ratio is not without its limitations and in certain circumstances, it may prove not to be the most accurate tool for valuation.
Understanding How the Price-to-Book Ratio Operates
The price-to-book ratio provides analysts and investors alike with a ratio of a company’s shares’ market value (i.e., their share price) which is set against the book value of equity. The book value of equity refers to the worth of a company’s assets that are made clear in the company’s balance sheet. When looking at the definition of book value, it refers to the difference that exists between the book value of assets and the book value of liabilities.
A company that has a P/B ratio that amounts to one indicates that its stock price trades in line with its book value i.e., the stock price of the company is fairly valued keeping in mind the P/B ratio. Companies that have high P/B ratios might be overvalued whereas those which have low P/B ratios could be undervalued.
It is important to compare P/B ratios of companies belonging to the same sector as certain industries are likely to have high P/B ratios. Therefore, it is pertinent to compare companies that have similar assets and liabilities.
A price-to-book ratio analysis is an important component of the broader value investing approach as it inherently assumes that the market is inefficient to a certain extent owing to which it is likely for companies to trade for less than they are worth at any given point in time.
Calculating the Price-to-Book Ratio
The price-to-book ratio of a company can be calculated with the formula provided below.
P/B ratio = market price per share/book value per share.
You need the following information handy in order to be able to calculate the P/B ratio of a company.
- The market price of its stock
- The total amount of assets of a company
- The total amount of liabilities of a company
- The total number of outstanding equity shares (this is listed under the shareholders’ section of a company’s balance sheet)
In order to understand what the book value per share is, you must follow the formula stated below in order to use the result to calculate the P/B ratio.
Book value per share = (assets – liabilities) / number of shares outstanding
Using an Example to Understand the P/B Ratio
Consider company ABC that has the following information made clear on its balance sheet in addition to having a stock price worth INR 25 per share.
- Assets = INR 100 Crores
- Liabilities = INR 75 Crores
- Outstanding shares = 10 Crores
In order to calculate the P/B ratio, we must first understand what company ABC’s book value and book value per share amount to.
Book value = INR 25 Crores (INR 100 Crores – INR 75 Crores)
Book value per share = INR 2.50 (INR 25 Crores / 10 Crore shares)
P/B Ratio = 10 (INR 25 stock price / 2.50 book-value-per share)
This means that the stock of company ABC is being traded at 10 times its book value. Whether or not this valuation is appropriate is dependent upon how the P/B ratio compares to the company’s value in the previous year and the ratio of other companies that operate in the same industry as company ABC.
Criticisms Associated with the P/B Ratio
While the price-to-book ratio can help analysts ascertain whether companies are overvalued or undervalued, there are certain limitations associated with it. These are as follows.
Capital Intensive Industries
This ratio is best suited to capital-intensive businesses like energy firms which feature ample assets in their ledgers. It isn’t as well suited to other business models.
Service-based firms that have a limited number of tangible assets can’t derive significant use from this ratio as it doesn’t take into account intangible assets like the brand name of a company or its goodwill and patents.
This ratio does not provide insight into companies that have sustained losses or have ample debt. Debt can enhance a company’s liabilities such that they overpower the book value of a company’s hard assets resulting in artificially high P/B ratios.
Non-operating issues can affect book values to the extent that they no longer reflect the real value of the assets under consideration.
While you might employ the price-to-book ratio to determine whether a company’s stock is overvalued or undervalued, it is important to bear in mind that this ratio has its limitations and should be supplemented by additional research.