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. 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
Book Value of Equity = Book Value of Assets minus Book Value of Liabilities
These book value figures all appear on the balance sheet.
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.