The Price to Book Ratio or Price to Book Multiple is the valuation metric which is used by investors to determine how much they are willing to pay for a company stock as compared to the book value of that company. This ratio is mainly used by investors to understand whether certain stocks are undervalued or overvalued.
The book value or equity of the company is simply what the company would be worth if it sold all of its assets and paid off all of its liabilities.
How is P/B Ratio calculated?
The formula that is used to calculate P/B ratio is,
P/B Ratio = Market Price per Share / Book Value per Share (BVPS)
It is calculated by taking the company’s market share price and dividing it by the company’s book value per share.
An example for how investors would use the P/B ratio would be,
Let us assume that X wants to invest in Y’s diner. Y’s diner has a book value of a hundred thousand dollars and fifty thousand shares outstanding resulting in a book value per share of two dollars.
The company currently trades at four dollars per share. By using the P/B ratio we can say that Y’s diner trades at two times its book value.
In other words the stock costs twice as much as the assets could be sold for.
What is the interpretation of P/B Ratio?
A high P/B ratio would indicate that a company’s stock is expensive whereas a low P/B ratio would indicate that a company might be cheap when compared to the company’s net assets.
A company might trade at a high P/B ratio when investors believe the company has a lot of growth potential.
In contrast a company might trade at a low P/B ratio when investors aren’t overly optimistic about the future performance.
A negative P/B ratio means the company has higher liabilities as compared to assets that are present.
A positive book value would mean the company has more assets than liabilities while a negative book value would mean that the company has more liabilities than assets.
Usually, any value which is under 1.0 is considered to be good enough and indicates an undervalued stock but investors tend to prefer and look at stocks which have a P/B value that is below 3.0.
What are the Pros of P/B ratio?
- Investors would typically use the price to book ratio where there’s a greater emphasis on the company’s assets rather than the company’s potential earning power.
- It’s typically used in liquidation situations where a company is broken up and sold.
- It helps figure out if an investor is paying too much to purchase a particular stock.
- It can be used as a benchmark against other companies, industries or the market as a whole on a net asset basis.
- P/B ratio is quite stable and the asset prices are not as volatile as compared to how it is in the case of earnings.
- The company’s valuation can be found and taken easily as it becomes easy to understand the big picture this way.
- It is simpler when it comes to valuation of companies such as start-ups which haven’t earned profits yet.
What are the Cons of P/B ratio?
- The P/B ratio alone is not enough to make an investment decision. It is only one of the many metrics available which is used by investors in order to evaluate stocks.
- This ratio does not prove to be helpful when balance sheet items are classified in a different manner because of accounting standards that aren’t the same. It becomes tough and difficult to compare the ratios among different companies and it may cause problems with this ratio on companies that aren’t US based.
- The book value can get distorted if the company has acquired any shares or if any recent write offs were made.
- It will become useless when it comes to how much the value of a company is.
- This is a metric which cannot be applied when it comes to companies which have negative net worth or even start-ups or companies that are going through a tough phase.
- For companies where mainly intangible assets are the source, their main, largest assets are not going to be accounted for in the balance sheet.
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