The price-to-book (P/B) ratio has been favored by value investors for decades and is widely used by market analysts. Traditionally, anything below 1.0 is considered a good P/B, indicating a potentially undervalued stock. However, value investors often consider stocks with a P/B below 3.0. It’s important to note that when determining whether a stock is undervalued and therefore a good investment, it can be difficult to pinpoint a specific numerical value of a “good” P/B ratio. Ratio analysis can vary by industry, and a good P/B ratio for one industry can be a bad 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. Specifically, it compares the company’s stock price to its book value per share (BVPS). Market capitalization (enterprise value) is the share price multiplied by the number of shares outstanding. Book value is the sum of assets – sum of liabilities and can be found on a company’s balance sheet. In other words, if a company has liquidated all of its assets and paid off all of its debts, the remaining value would be the book value of the company.
It’s helpful to identify some general parameters or a range for P/B, and then consider various other factors and metrics that more accurately interpret P/B and predict a company’s growth potential.
Calculation of the P/B ratio
As mentioned earlier, the P/B ratio examines a company’s stock price relative to its BVPS. The ratio is calculated as follows:
P/B ratio = market price per share ÷ book value per share (BVPS)
- BVPS = (Total Shareholder Equity – Preferred Equity) ÷ Total Shares Outstanding
Using the P/B ratio to value the stock
The P/B ratio should not be used as the sole valuation of a stock because while a low P/B can indicate an undervalued company, it can also reflect serious underlying issues within that company. A weakness in assessing the P/B ratio is that it doesn’t take into account things like future earnings prospects or intangible assets. However, the P/B ratio helps identify hyped companies that have rising share prices with no assets.
Other potential problems with using the P/B ratio arise from the fact that a number of things, such as Recent acquisitions, recent write-downs or share buybacks, for example, can skew the book value in the equation. When looking for undervalued stocks, investors should consider several valuation measures to complement the P/B ratio.
A commonly used metric is return on equity (ROE), which shows how much profit a company makes from equity. The P/B ratio and ROE usually correlate well, and any large discrepancy between them can be a cause for concern.
The final result
Investors may find the P/B ratio a useful metric because it provides a good way to compare a company’s market cap to its book value. But determining a standard and an acceptable price-to-book ratio is not 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 can also indicate underlying problems at the company.