Using the Price-To-Book (P/B) Ratio to Evaluate Companies

What Is the Price-To-Book (P/B) Ratio?

What price should investors pay for a company’s equity shares? If the goal is to unearth high-growth companies selling at low-growth prices, the price-to-book ratio (P/B) offers investors an effective approach to finding undervalued companies.

The P/B ratio can also help investors identify and avoid overvalued companies. However, this ratio has its limitations and there are circumstances where it may not be the most effective metric for valuation.

How the Price-to-Book (P/B) Ratio Works

Price-to-book value (P/B) is the ratio of the market value of a company’s shares (share price) over its book value of equity. The book value of equity, in turn, is the value of a company’s assets expressed on the balance sheet. The book value is defined as the difference between the book value of assets and the book value of liabilities.

Investors use the price-to-book value to gauge whether a stock is valued properly. A P/B ratio of one means that the stock price is trading in line with the book value of the company. In other words, the stock price would be considered fairly valued, strictly from a P/B standpoint. A company with a high P/B ratio could mean the stock price is overvalued, while a company with a lower P/B could be undervalued.

However, the P/B ratio should be compared with companies within the same sector. The ratio is higher for some industries than others. So, it’s important to compare it to companies with a similar makeup of assets and liabilities.

A P/B ratio analysis is an important part of an overall value investing approach. Such an approach inherently assumes that the market is somewhat inefficient and therefore, at any given time, companies are trading for significantly less than their actual worth.

A Low Price-to-Book (P/B) Ratio

A P/B ratio with lower values, particularly those below one, could be a signal to investors that a stock may be undervalued. In other words, the stock price is trading at a lower price relative to the value of the company’s assets.

Conversely, market participants might believe that the company’s asset value is overstated. If the company has overvalued assets, investors would likely avoid the company’s shares because there is a chance that asset value will face a downward correction by the market, leaving investors with negative returns.

A low P/B ratio could also mean the company is earning a very poor (even negative) return on its assets (ROA). If the company has poor earnings performance, there is a chance that new management or new business conditions will prompt a turnaround in prospects and give strong positive returns. Even if this does not happen, a company trading at less than book value can be broken up for its asset value, earning shareholders a profit.

For value investors, the P/B ratio is a tried and true method for finding low-priced stocks that the market has neglected. Value investors, including Warren Buffet, search for opportunities where they believe the market has wrongly valued or priced a stock. A P/B ratio of less than one could be an indicator of an undervalued company that the market has misunderstood.

A High Price-to-Book (P/B) Ratio

A P/B ratio that’s greater than one suggests that the stock price is trading at a premium to the company’s book value. For example, if a company has a price-to-book value of three, it means that its stock is trading at three times its book value. As a result, the stock price could be overvalued relative to its assets.

A high share price versus asset value could also mean the company is earning a high ROA. However, the high stock price could indicate that most of the goods news regarding the company has already been priced into the stock. As a result, any additional good news might not lead to a higher stock price.

P/B provides a valuable reality check for investors seeking growth at a reasonable price. P/B is often looked at in conjunction with return on equity (ROE), a reliable growth indicator. ROE represents a company’s profit or net income as compared to shareholders’ equity, which is assets minus debt. ROE is important because it shows how much profit is being generated with the company’s assets.

Large discrepancies between P/B and ROE are often a red flag. Overvalued growth stocks can have a combination of low ROE and high P/B ratios. If a company’s ROE is growing, its P/B ratio should be doing the same.

Criticisms of the Price-to-Book (P/B) Ratio

Although the P/B ratio can help investors identify which companies might be overvalued or undervalued, the ratio has its limitations.

Capital Intensive Industries

The P/B ratio is only considered useful in practice when applied to capital-intensive businesses, such as energy or transportation firms, large manufacturers, or financial businesses with a significant amount of assets on their books.

Intangible Assets

Book value ignores intangible assets such as a company’s brand name, goodwill, patents, and other intellectual property. That means it does not carry much meaning for service-based firms with few tangible assets.

For example, the bulk of Microsoft’s asset value is determined by its intellectual property rather than its physical property. As a result, Microsoft’s share value bears little relation to its book value.

Debt Levels

Book value does not offer insight into companies that carry high debt levels or sustained losses. Debt can boost a company’s liabilities to the point where they wipe out much of the book value of its hard assets, creating artificially high P/B values.

Highly leveraged companies, such as cable and wireless telecommunications companies, have P/B ratios that understate their assets. For companies with a string of losses, book value can be negative and, hence, meaningless.

Asset Values

Behind-the-scenes, non-operating issues can impact book value so much that it no longer reflects the real value of the assets.

First, the book value of an asset reflects its original cost, which is not informative when assets are aging. Second, the value of assets might deviate significantly from the market value if the earnings power of the assets has increased or declined since they were acquired. Inflation–or rising prices–alone may well ensure that the book value of assets is less than the current market value.

At the same time, companies can boost or lower their cash reserves, which, in effect, changes book value but with no change in operations. For example, if a company chooses to take cash off the balance sheet, placing it in reserves to fund a pension plan, its book value will drop. Share buybacks also distort the ratio by reducing the capital on a company’s balance sheet.

How to Calculate the Price-to-Book (P/B) Ratio

The P/B ratio can be calculated as follows:

In order to calculate the P/B Ratio, the following information is needed:

• Market price of the stock
• Total amount of assets from the balance sheet
• Total amount of liabilities from the balance sheet
• Total number of outstanding equity shares from the shareholders’ section of the balance sheet

First, we need to calculate the book value per share, which is in the denominator of the P/B ratio formula. As stated earlier, we know that book value equals a company’s total assets minus its liabilities. To arrive at book-value-per share, divide the book value by the…