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.
But 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. The market cap or value of a company is its share price multiplied by the number of outstanding shares. The book value is the net assets of a company, 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 value and forecast a company's potential for growth.
Calculating P/B Ratio
P/B Ratio=Book Value of EquityStock Pricewhere:Book Value of Equity=Book value of assets minusbook value of liabilities.
These book value figures all appear on the balance sheet. To get the book value per share, you'll need to divide the difference by the current total shares outstanding.
Using P/B to Evaluate Stock
The P/B ratio should not be used as a single evaluation of a stock because, while a low P/B can indeed reveal an undervalued stock, it can also indicate a company with serious underlying problems. A weakness in a P/B 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, or 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. That's because the book value can provide a good way to compare a company's market price 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.