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What price should you pay for a company's shares? If the goal is to unearth high-growth companies selling at low-growth prices, the price-to-book ratio (P/B) offers investors a handy, albeit fairly crude, approach to finding undervalued companies. It is, however, important to understand exactly what the ratio can tell you and when it may not be an appropriate measurement tool.

Difficulties of Determining Value
Let's say you identify a company with strong profits and solid growth prospects. How much should you be prepared to pay for it? To answer this question you might try using a fancy tool like discounted cash flow analysis to provide a fair value. But DCF can be tricky to get right, even if you can manage the math. It requires an accurate estimate of future cash flows, but it can be awfully hard to look more than a year or two into the future. DCF also demands the return required by investors on a given stock, another number that is difficult to produce accurately.

What Is P/B?
There is an easier way to gauge value. Price-to-book value (P/B) is the ratio of market price 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. This number is defined as the difference between the book value of assets and the book value of liabilities.

Assume a company has $100 million in assets on the balance sheet and $75 million in liabilities. The book value of that company would be $25 million. If there are 10 million shares outstanding, each share would represent $2.50 of book value. If each share sells on the market at $5, then the P/B ratio would be 2 (5/2.50).

What Does P/B Tell Us?
For value investors, P/B remains a tried and tested method for finding low-priced stocks that the market has neglected. If a company is trading for less than its book value (or has a P/B less than one), it normally tells investors one of two things: either the market believes the asset value is overstated, or the company is earning a very poor (even negative) return on its assets.

If the former is true, then investors are well advised to steer clear of 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. If the latter is true, 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 doesn't happen, a company trading at less than book value can be broken up for its asset value, earning shareholders a profit.

A company with a very high share price relative to its asset value, on the other hand, is likely to be one that has been earning a very high return on its assets. Any additional good news may already be accounted for in the price.

Best of all, P/B provides a valuable reality check for investors seeking growth at a reasonable price. Large discrepancies between P/B and ROE, a key growth indicator, can sometimes send up a red flag on companies. Overvalued growth stocks frequently show 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.

No Magic Bullet
Despite its simplicity, P/B doesn't do magic. First of all, the ratio is really only useful when you are looking at capital-intensive businesses or financial businesses with plenty of assets on the books. Thanks to conservative accounting rules, book value completely ignores intangible assets like brand name, goodwill, patents and other intellectual property created by a company. Book value doesn't carry much meaning for service-based firms with few tangible assets. Think of software giant Microsoft, whose bulk asset value is determined by intellectual property rather than physical property; its shares have rarely sold for less than 10 times book value. In other words, Microsoft's share value bears little relation to its book value.

Book value doesn't really 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 - like those involved in, say, cable and wireless telecommunications - have P/B ratios that understate their assets. For companies with a string of losses, book value can be negative and hence meaningless.

Behind-the-scenes, non-operating issues can impact book value so much that it no longer reflects the real value of assets. For starters, the book value of an asset reflects its original cost, which doesn't really help when assets are aging. Secondly, their value might deviate significantly from market value if the earnings power of the assets has increased or declined since they were acquired. Inflation alone may well ensure that 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.

The Bottom Line
Admittedly, the P/B ratio has shortcomings that investors need to recognize. But it offers an easy-to-use tool for identifying clearly under or overvalued companies. For this reason, the relationship between share price and book value will always attract the attention of investors.

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