What is P/B Ratio
Key Takeaways
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A company's market worth in relation to the value of its assets and costs is its price-to-book value (P/B) ratio.
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The P/B ratio may be used to identify potential investment opportunities.
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The price-to-book value ratio does not take into account the intangible assets of a company.
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A company with a P/B ratio of 1 or less is generally considered favourable for investment.
Understanding the true value of a company is crucial for making informed investment decisions. One metric that stands out in this regard is the price to book ratio. This financial ratio offers a unique perspective by comparing a company’s market value to its book value, providing insights that are not immediately apparent through market prices alone. But how exactly does this ratio work, and why is it so important for investors seeking to uncover hidden value in their portfolios?
What is Price-to-Book Ratio?
The price-to-book ratio, or the PBV ratio, is a method for determining the worth of a stock. It is a ratio of a company's book value to market capitalisation. It can also be referred to as the ratio of book value per share to stock price per share of a company. Investors, banks, and other financial institutions frequently use it.
Many of the things on the balance sheet may be sold at greater or lower prices than their present value in the books. Yet, a company's book value is a pretty accurate estimate of its liquidation value in the case of bankruptcy.
Investors may get a better idea of how the market values a company by comparing the share price to its current book value. A high price-to-book ratio indicates that the market is optimistic about future performance. This is because the value they are assigning to the company surpasses the book value of its stock.
Formula To calculate the P/B Ratio
The price-to-book value ratio includes two key metrics of a company – market capitalisation and net asset value. So, to calculate the P/B ratio, you must have proper data on these two metrics.
In order to determine a company's market capitalisation, you have to multiply the stock's current market price by the total number of outstanding shares.
Market capitalisation = Stock's price x Number of outstanding shares
Now, the next step is to determine the net asset value of the company. For this, first sum up the book values of all the assets shown on a company's balance sheet. Then, subtract the total amount of all debts and obligations.
Book Value of Assets = Total Assets – Total Liabilities
This value reflects an organisation's equity value.
Using these two values, you can calculate the price-to-book value. The formula is as follows:
P/B Ratio = Market Capitalisation / Book Value of Assets
You can also calculate the Price-to-Book Ratio using the following formula:
P/B Ratio = Market Price Per Share / Book Value of Assets Per Share
An Illustration of Price to Book Value Ratio
Let's analyse the process for determining the Price-To-Book Ratio for company ABC. Assume they have 10000 outstanding shares and a market price of ₹125 per share. So, the market capitlisation is ₹12,50,000 (₹125 x 10000).
| Particulars | Value |
|---|---|
Assets | |
Cash and cash equivalents | 50,000 |
Accounts receivable | 90,000 |
Inventory | 20,000 |
Machinery | 5,00,000 |
Equipment | 2,00,000 |
Liabilities | |
Accounts payable | 40,000 |
Outstanding expenses | 60,000 |
Short-term loans | 50,000 |
Long-term debts | 1,20,000 |
Other non-current liabilities | 50,000 |
The balance statement shows that they have total assets of ₹8,60,000 and total liabilities of ₹3,20,000. Their net asset value is thus equal to ₹5,40,000 (8,60,000– 3,20,000). This is the book value.
Therefore, the P/B ratio of company ABC is as follows.
P/B Ratio = Market Capitalisation / Book Value of Assets
= Rs. 12,50,000 / Rs. 5,40,000 = 2.31
Uses of P/B Ratio
As an investor, you can use the P/B ratio for the following.
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While investing in a company, you should know the P/B ratio, which compares the price per share to the net asset value. Using this comparison, you can assess whether it is a wise investment.
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Many investors also want to value the company's shares. The P/B ratio can be especially useful for evaluating companies in the banking, insurance, or investment industries.
However, as an investor, you must keep one thing in mind. Companies that must maintain substantial assets, particularly those with significant R&D expenditures or long-term fixed assets, cannot benefit from this ratio.
Limitations of Price-To-Book Ratio
Let's now understand the limits of using the price-to-book value ratio.
The sole factor considered for determining book value is the firm's monetary value. The P/B ratio excludes intangible economic assets like human capital.
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The book and market values of assets may fluctuate dramatically as a result of changes in technology, intellectual property, inflation, and other factors.
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The management's choice of accounting policies can have a big influence on book value.
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The differences in book value may also result from the business model. The book value of assets of a firm that outsources production will be lower than that of a company that manufactures its products.
P/B Ratio vs Return on Equity
To understand the company's financial health better, it's essential to compare the price to book ratio with other metrics like Return on Equity (ROE). While the P/B ratio measures the market's valuation of a company's book value, ROE indicates how effectively a company is using its equity to generate profits. A company with a high P/B ratio and low ROE might be overvalued, whereas a company with a low P/B ratio and high ROE could be undervalued. Here's a quick comparison:
| Metric | Description | Indicates |
|---|---|---|
P/B Ratio | Measures market value vs. book value | Overvalued or undervalued stock |
ROE | Measures profitability relative to equity | Efficiency in generating profits |
P/B ratio vs Price to Tangible Book Ratio
Another useful comparison is between the price to book ratio and the price to tangible book ratio (PTB). While the PB ratio meaning includes all assets, the PTB ratio excludes intangible assets. This can provide a clearer picture of a company's tangible net worth. For instance, a company with significant intangible assets might have a high P/B ratio but a more reasonable PTB ratio, making it a better investment.
Interpreting Price-To-Book Ratio
Intangible assets are excluded from the book value used in the computation, so the P/B ratios of such firms may appear higher than expected. Microsoft, Google, and Tesla are a few examples of such companies. Yet, the P/B ratio might be a crucial instrument for assessing a capital-intensive organisation. These companies have a lot of physical assets. Banks are one such example.
Low Price-To-Book Ratio
A low P/B ratio of less than 1.0 indicates that the stock price is trading below the company's book value. Low P/B ratios can indicate that a firm is undervalued. They can also indicate major internal issues. Therefore, a thorough analysis is necessary.
P/B Ratio of 1 to 3
A P/B ratio of 1 to 3 indicates that the stock price is trading at about the company's book value. A stock is considered to be selling at a premium when its P/B ratio is assessed to be higher than 1.0. Most of the stocks have a P/B ratio between 1 and 3.
Price-To-Book Ratio Exceeding 3.0
A high P/B ratio of more than 3.0 indicates that the stock price is trading above the company's book value. A high price-to-book ratio means the company is overvalued and has no assets. But this may also be a result of the P/B ratio's restriction, which prevents it from taking into account things like intangible assets or forecasts for future earnings. Due to the exclusion of their intangible assets from the computation, many excellent firms might have high P/B ratios.
How do you Determine a Good Price-To-Book Ratio?
The ideal price-to-book ratio varies depending on the type of business. Value investors typically regard a P/B ratio of less than 1.0 as a sign of an undervalued stock. A P/B ratio of less than 3 is acceptable to the majority of investors. However, the definition of a "good P/B ratio" is not absolute.
Businesses related to the IT sector have a large amount of intangible assets. Thus, a P/B ratio of less than 3.0 might be a favourable one. For businesses that have a lot of physical assets, like those in the banking industry, a P/B ratio of more than 1.5 might be problematic.
In general, you need a low P/B when compared to other firms in the same industry.
Conclusion
The price-to-book value (PBV) ratio compares the market capitalisation and the net assets of a company. As an investor, you can use the P/B ratio to select undervalued stocks. However, it does not take into account the intangible assets of a company. So you should look at other ratios before making an investment. Good trading platforms like Kotak Securities provide several indicators and tools for analysing stocks on different parameters. The PBV ratio can be used to choose companies in capital-intensive industries like transportation and telecom. To choose appropriate stocks, it is crucial to contrast a firm's PBV ratio with the PBV ratio of the particular industry.
FAQs On Price to Book Value Ratio
Is there a good P/B value ratio for a stock?
There are no fixed criteria for a good P/B ratio. However, value investors frequently choose values below 1.0, indicating the possibility of discovering a cheap stock. However, stocks with a less stringent P/B value of less than 3.0 may commonly serve as the benchmark for other investors.
Why price-to-book ratio is so important?
The price-to-book ratio is an important financial metric, as it helps investors assess a company's worth and growth prospects. The P/B ratio evaluates a company's market valuation in relation to its book value.
Can we get a negative P/B ratio?
Yes, we can get a negative P/B ratio. It happens when a company's liabilities exceed its assets. It may indicate financial stress or accounting issues.
Can the P/B ratio of a company change?
Yes, the P/B ratio of companies can change due to fluctuations in their stock price and changes in their book value.
Can I use the P/B ratio to compare companies within the same industry?
Yes, the P/B ratio can be useful for comparing companies within the same industry. You can use it to identify relative undervaluation or overvaluation.
