What is the Book-to-Market Ratio
The book-to-market ratio is used to find the value of a company by comparing the book value of a firm to its market value. Book value is calculated by looking at the firm's historical cost, or accounting value. Market value is determined in the stock market through its market capitalization.
The formula for the book-to-market ratio is:
Book-to-market ratio = book value of firm / market value of firm
Book-to-market ratio = common shareholders’ equity / market capitalization
BREAKING DOWN Book-to-Market Ratio
Book Value and Market Value
The value of a firm is assessed in two ways – its book value and its market value. The book value of a firm is its historical cost or accounting value calculated from the company’s balance sheet. Book value can be calculated by subtracting total liabilities, preferred shares, and intangible assets from the total assets of a company. In effect, the book value represents how much a company would have left in assets if it went out of business today. Some analysts use the total shareholders' equity figure on the balance sheet as the book value.
A market value of a publicly traded company is determined by calculating its market capitalization, which is simply the total number of shares outstanding multiplied by the current share price. The market value is the price that investors are willing to pay to acquire or sell the stock in the secondary markets. Since it is determined by supply and demand in the market, it does not always represent the actual value of a firm.
If the market value of a company is trading higher than its book value per share, it is considered to be overvalued. If the book value is higher than the market value, analysts consider the company to be undervalued. To compare a company’s net asset value or book value to its current or market value, the book-to-market ratio is used.
How to Use the Book-to-Market Ratio
The book-to-market ratio attempts to identify undervalued or overvalued securities by taking the book value and dividing it by market value. It helps to determine the market value of a company relative to its actual worth. Investors and analysts use this comparison ratio to differentiate between the true value of a publicly traded company and investor speculation.
In basic terms, if the ratio is above 1 then the stock is undervalued; if it is less than 1, the stock is overvalued. A ratio above 1 indicates that the stock price of a company is trading for less than the worth of its assets. A high ratio is preferred by value managers who interpret it to mean that the company is a value stock, that is, it is trading cheaply in the market compared to its book value.
A book-to-market ratio below 1 implies that investors are willing to pay more for a company than its net assets are worth. This could indicate that the company has healthy future profit projections and the investors are willing to pay a premium for that possibility. Technology companies, and other companies in industries which do not have a lot of physical assets, tend to have a low book-to-market ratio.
The market-to-book ratio, also called the price-to-book ratio, is the reverse of the book-to-market ratio. Like the book-to-market ratio, it seeks to evaluate whether the stock a company is over or undervalued by comparing the price of all outstanding shares with the net assets of the company.
A market-to-book ratio above 1 means that the company’s stock is overvalued, and below 1 indicates that its undervalued; the reverse is the case for the book-to-market ratio. Analysts can use either ratios to run a comparison on the book and market value of a firm.