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.
How to Calculate Price-to-Book (P/B) 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.
Example of How to Use the P/B Ratio
Example 1: To illustrate how the Price-to-Book (P/B) ratio works, consider a company called ABC Inc. Suppose ABC Inc.’s share price is ₹80, and its book value per share is ₹20. To calculate the P/B ratio, divide the share price by the book value per share:
P/B Ratio = ₹80 / ₹20 = 4
This result means the market value of ABC Inc.’s shares is four times their book value. If the P/B ratio were below 1, it would suggest that the stock might be undervalued. Conversely, a P/B ratio above 1 could indicate potential overvaluation. It is important to compare this ratio with industry peers to understand its context fully.
Example 2: Consider another scenario where a company has ₹100 crore in assets and ₹75 crore in liabilities. Subtracting liabilities from assets gives the company’s book value:
Book Value = ₹100 crore – ₹75 crore = ₹25 crore
With 10 crore shares outstanding, the book value per share is:
Book Value per Share = ₹25 crore / 10 crore = ₹2.50
If the current share price is ₹5, the P/B ratio would be:
P/B Ratio = ₹5 / ₹2.50 = 2.0
This ratio shows that the market price is twice the book value per share. Whether this indicates overvaluation depends on comparing it with similar companies in the same sector. For companies with few tangible assets, the P/B ratio might not be as informative, and other valuation methods could be more appropriate.
These examples demonstrate how to calculate the P/B ratio in different scenarios. Always consider the industry context and compare with similar companies before drawing conclusions based solely on the P/B ratio.
FAQs
A good Price-to-Book (PB) ratio typically depends on the industry and the company’s financial health. A good PB ratio is typically less than 1, indicating potential undervaluation, but it should be compared with industry peers for context.
The PE ratio measures a company’s current share price relative to its per-share earnings, making it useful for evaluating profitability. The PB ratio, on the other hand, compares the share price to the book value per share, which is useful for assessing the valuation of a company’s assets. Investors often use both ratios in conjunction to get a comprehensive view of a company’s financial health and valuation.
The full form of PB ratio is Price-to-Book ratio.
