Price-to-book ratio (also known as P/B) is a helpful financial ratio investors use to determine how much of the company’s value is being dictated by the market. The ratio is a company’s market price per share divided by its book value per share. It is commonly used to quantify how under or overvalued a company’s stock is.
How Does Price-to-Book Ratio Work?
Price-to-book ratio is, in essence, capturing the company’s market value per share to its book value per share. This helps investors dictate whether the company’s stock is inflated due to its perceived value.
In order to calculate this ratio one must use a company’s balance sheet (to find the book value) and current stock value (to find market value).
What Is Book Value?
A company’s book value (BV) is their tangible assets’ “true” value. It is given this name since it is the value that is recorded in a company’s financial statements.
In short, it is the sum of the company’s assets and liabilities. It would also in theory be the amount stockholders would receive if the company was liquidated.
What Is Market Value?
Market value (MV) focuses and quantifies the value of intangible assets a company has. In short, it is the amount the stock market dictates a public company’s stock price to be.
Since market value is representing a company’s perceived value, it tends to be greater than its book value.
What Is an Example of Price-to-Book Ratio?
Say you are trying to calculate the price-to-book ratio of Company XYZ. You would first have to look at Company XYZ’s balance sheet to find out their BV.
On their balance sheet it shows they have $50 million in assets and $20 million in liabilities. In order to get the book value, you would subtract Company XYZ’s liabilities from its assets, resulting in the BV being $30 million.
In order to find the book value per share (BVPS), you would have to take the Company XYZ’s book value and divide it by its outstanding shares. Since it has 5 million outstanding shares, therefore the BVPS would be $6 per share.
However, Company XYZ’s market value per share is shown as $24 on the stock market. This would mean that the price-to-book ratio of Company XYZ is 4x (24/6 = 4).
This shows that the market values Company XYZ’s stock four times greater than its true price.
What Is a Good Price-to-Book Ratio?
A good price-to-book ratio is usually under the threshold of 1. This means that the stock is undervalued and has the potential to increase in price.
Therefore, it could be an attractive investment option since you can get a profitable return. Alternatively, it is important to note that a low price-to-book ratio may also show that there may be something fundamentally wrong with the company since they have a higher value in BV than market value.
On the contrary, when a P/B ratio is 2x or 3x it shows that the company is highly overvalued. This means that investors have higher expectations of the company and therefore overvaluing it.
However, this is typically an unattractive investment option since it can signal that the stock’s price will decrease to its true value in the future.
How Accurate Is Price-to-Book Ratio?
Since a company’s stock price fluctuates constantly, it is hard to gauge what the actual P/B ratio of a company is. However, if a stock’s market value seems to trend around a specific value, this ratio could be a good guideline on whether the company is over or undervalued.
Additionally, it is important to know that accounting principles may vary depending on the company and where its headquarters are based. These various rules may alter a company’s book value making it difficult to accurately compare competitor companies by their P/B ratio.
Lastly, investors may need to dig further to fully understand a company’s price-to-book ratio. Even though this financial ratio may be great supporting evidence on whether a company is an attractive investment, it is not advised to solely base an investment decision on this ratio.
Why Is Price-to-Book Ratio Important?
Overall, the price-to-book ratio is a great starting point to dictate whether a company could be a potential investment option. It can guide investors into looking at other financial ratios to see why a company may be over or undervalued.
How a Financial Advisor Can Help
Price-to-book ratios can help guide on making decisions or simply provide context about a company. However, choosing which company to invest in can be daunting especially when you are unsure on how to research and collect information.
A financial advisor can help customize a portfolio for your investment needs and assist you throughout your investment journey. Learn more about how to get a financial advisor here!
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