What Is the Book-to-Market Ratio?
The book-to-market ratio is one indicator of a company's value. The ratio compares a firm's book value to its market value. A company's book value is calculated by looking at the company's historical cost, or accounting value. A firm's market value is determined by its share price in the stock market and the number of shares it has outstanding, which is its market capitalization.
- The book-to-market ratio helps investors find a company's value by comparing the firm's book value to its market value.
- A high book-to-market ratio might mean that the market is valuing the company's equity cheaply compared to its book value.
- Many investors are familiar with the price-to-book ratio, which is simply the inverse of the book-to-market ratio formula.
Understanding the Book-to-Market Ratio
The book-to-market ratio compares a company's book value to its market value. The book value is the value of assets minus the value of the liabilities. The market value of a company is the market price of one of its shares multiplied by the number of shares outstanding. The book-to-market ratio is a useful indicator for investors who need to assess the value of a company.
The formula for the book-to-market ratio is the following:
Book-to-Market=Market CapCommon Shareholders’ Equity
What Does the Book-to-Market Ratio Tell You?
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. The book-to-market ratio is used to compare a company’s net asset value or book value to its current or 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.
The 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.
How to Use the Book-to-Market Ratio
The book-to-market ratio identifies undervalued or overvalued securities by taking the book value and dividing it by the market value. The ratio determines 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 considered 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 investors are willing to pay a premium for that possibility. Technology companies and other companies in industries that do not have a lot of physical assets tend to have a low book-to-market ratio.
Difference Between the Book-to-Market Ratio and Market-to-Book 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 a company's stock is over or undervalued by comparing the market 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. A ratio below 1 indicates that it may be undervalued; the reverse is the case for the book-to-market ratio. Analysts can use either ratio to run a comparison on the book and market value of a firm.