The price-to-book (P/B) ratio has been favored by value investors for decades and is widely used by market analysts. Traditionally, any value under 1.0 is considered a good P/B value, indicating a potentially undervalued stock. However, value investors often consider stocks with a P/B value under 3.0. It is important to note that it can be difficult to pinpoint a specific numeric value of a "good" P/B ratio when determining if a stock is undervalued and therefore, a good investment. Ratio analysis can vary by industry, and a good P/B ratio for one industry may be a poor ratio for another.
The Basics of the P/B Ratio
The P/B ratio compares a company's market capitalization, or market value, to its book value. Specifically, it compares the company's stock price to its book value per share (BVPS). The market capitalization (company's value) is its share price multiplied by the number of outstanding shares. The book value is the total assets - total liabilities and can be found in a company's balance sheet. In other words, if a company liquidated all of its assets and paid off all its debt, the value remaining would be the company's book value.
It's helpful to identify some general parameters or a range for P/B value, and then consider various other factors and valuation measures that more accurately interpret the P/B ratio and forecast a company's potential for growth.
Calculating P/B Ratio
As stated earlier, the P/B ratio examines a company's stock price to its BVPS. The ratio is calculated as follows:
P/B Ratio = Market Price per Share ÷ Book Value per Share (BVPS)
- BVPS = (Total Shareholder Equity - Preferred Equity) ÷ Total Outstanding Shares
Using P/B Ratio to Evaluate Stock
The P/B ratio should not be used as a single evaluation of a stock because, while a low P/B may mean an undervalued company, it can also be a result of serious underlying problems within that company. A weakness in a P/B Ratio evaluation is that it fails to factor in things such as future earning prospects or intangible assets. However, the P/B ratio helps to identify hyped-up companies that have surging stock prices with no assets.
Other potential problems in using the P/B ratio stem from the fact that any number of things, such as recent acquisitions, recent write-offs, or share buybacks, can distort the book value figure in the equation. In searching for undervalued stocks, investors should consider multiple valuation measures to complement the P/B ratio.
One measure commonly used is return on equity (ROE) which indicates how much profit a company generates from shareholders' equity. P/B ratio and ROE usually correlate well, and any large discrepancy between them may indicate a cause for concern.
The Bottom Line
Investors may find the P/B ratio to be a useful metric because it can provide a good way to compare a company's market capitalization to its book value. But determining a standard and acceptable price-to-book ratio isn't always easy. As mentioned above, this varies by industry. In some cases, a lower P/B ratio could mean the stock is undervalued, but it may also point to fundamental problems with the company.