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What is 'Price-To-Book Ratio - P/B Ratio'

Companies use the price-to-book ratio to compare a firm's market to book value by dividing price per share by book value per share. Some people know it as the price-equity ratio.

We can calculate this as:

P/B ratio = market price per share / book value per share

In this equation, book value per share =  (total assets - total liabilities) / number of shares outstanding

A lower P/B ratio could mean the stock is undervalued. However, it could also mean something is fundamentally wrong with the company. As with most ratios, this varies by industry.

This ratio also indicates whether you're paying too much for what would remain if the company went bankrupt immediately.

For more, check out Digging Into Book Value

BREAKING DOWN 'Price-To-Book Ratio - P/B Ratio'

The P/B ratio reflects the value that market participants attach to a company's equity relative to its book value of equity. A stock's market value is a forward-looking metric that reflects a company's future cash flows. The book value of equity is an accounting measure based on the historic cost principle, and reflects past issuances of equity, augmented by any profits or losses, and reduced by dividends and share buybacks.

The Differences Between the Market and Book Value of Equity

Due to accounting conventions on treatment of certain costs, the market value of equity is typically higher than the book value of a company, producing a P/B ratio above 1. Under certain circumstances of financial distress, bankruptcy or expected plunges in earnings power, a company's P/B ratio can dive below 1. Because accounting principles do not recognize brand value and other intangible assets, unless the company derived them through acquisitions, companies expense all costs associated with creating intangible assets immediately. For example, companies must expense research and development costs, reducing a company's book value. However, these R&D outlays can create unique production processes for a company or result in patents that can bring royalty revenues going forward. While accounting principles favor a conservative approach in capitalizing costs, market participants may raise the stock price because of such R&D efforts, resulting in wide differences between the market and book values of equity.

Advantages and Disadvantages to the P/B Ratio

Investors find the P/B ratio useful because the book value of equity provides a relatively stable and intuitive metric they can easily compare to the market price. Also, the P/B ratio can be used for firms with positive book values and negative earnings since negative earnings render price-to-earnings ratios useless, and there are fewer companies with negative book values than companies with negative earnings. However, when accounting standards applied by firms vary, P/B ratios may not be comparable, especially for companies from different countries. Also, P/B ratios can be less useful for service and information technology companies with little tangible assets on their balance sheets. Finally, the book value can become negative because of a long series of negative earnings, making the P/B ratio useless for relative valuation.

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