It is difficult to pinpoint a specific numeric value of a "good" price-to-book (P/B) ratio when determining if a stock is undervalued and therefore a good investment. Ratio analysis can vary by industry. A good P/B ratio for one industry might be a poor ratio for another.
The price to book ratio compares a company's market value to its book value. The market 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.
The 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.
P/B value = stock price/book value of equity, where "book value of equity" is defined as the book value of assets minus the book value of liabilities; these are figures that appear on the balance sheet.
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.