What is the 'Price-To-Book Ratio - P/B Ratio'
The price-to-book ratio (P/B Ratio) is a ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share.
Also known as the "price-equity ratio".
A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware that this varies by industry.
This ratio also gives some idea of whether you're paying too much for what would be left if the company went bankrupt immediately.
For more, check out Digging Into Book Value
BREAKING DOWN 'Price-To-Book Ratio - P/B Ratio'
The P/B ratio reflects the value that market participants attach to a company's equity relative to its book value of equity. A stock's market value is a forward-looking metric that reflects a company's future cash flows. The book value of equity is an accounting measure that is based on the historic cost principle, and reflects past issuances of equity, augmented by any profits or losses, and reduced by dividends and share buybacks.
The Differences Between the Market and Book Value of Equity
Due to accounting conventions on treatment of certain costs, the market value of equity is typically higher than the book value of a company, producing a P/B ratio above 1. Under certain circumstances of financial distress, bankruptcy or expected plunges in earnings power, a company's P/B ratio can dive below 1. Because accounting principles do not recognize brand value and other intangible assets, unless they are derived through acquisitions, all costs associated with creating intangible assets are expensed immediately. For example, research and development (R&D) costs must be expensed, reducing a company's book value. However, these R&D outlays can create unique production processes for a company, or result in patents that can bring royalty revenues going forward. While accounting principles favor a conservative approach in capitalizing costs, market participants may raise the stock price as a result of such R&D efforts, resulting in wide differences between the market and book values of equity.
Advantages and Disadvantages to the P/B Ratio
Investors find the P/B ratio useful because the book value of equity provides a relatively stable and intuitive metric that can be easily compared to the market price. Also, the P/B ratio can be used for firms with positive book values and negative earnings since negative earnings render price-to-earnings ratios useless, and there are fewer companies with negative book values than companies with negative earnings. However, when accounting standards applied by firms vary, P/B ratios may not be comparable, especially for companies from different countries. Also, P/B ratios can be less useful for services and information technology companies with little tangible assets on their balance sheets. Finally, the book value can become negative as a result of a long series of negative earnings, making the P/B ratio useless for relative valuation purposes.