There are lots of companies listed on the stock exchange. For this reason, it becomes more rigorous to choose which company to invest in for an investor.
You don't have to invest just in gut feeling. Nevertheless, you can start researching stocks using various financial tools.
There are a few ratios that help us to analyze a stock such as return on equity, earnings per share, price to earnings ratio, price to book ratio, and so on. In this context, we will discuss the price-to-book ratio.
What is the Price to Book Ratio?
The price-to-book ratio is a valuation ratio that evaluates a company's current market price to its book value. The ratio shows how much equity investors are paying for each rupee in net assets. Price to book value is a financial ratio that compares a company's current market price of the share to its book value.
Investors or analysts use the ratio to determine whether the stock is overvalued or undervalued. The price-to-book ratio gauges the difference between the current share price and book value per share.
The formula for Price to Book Ratio
The price-to-book ratio is calculated by dividing the market price by the book value per share. The formula is as follows
Price to Book Ratio = Market Price per Share / Book Value per Share
Where,
Market Price Per Share = The current share price of a company.
Book Value per Share Formula = (Total Assets - Total Liabilities) / No. of outstanding shares
You may find information about the market value per share, on stock trading portals. To determine the total assets, total liabilities, and the number of outstanding shares, you must locate the company's balance sheet.
This financial report may be found on the "financials" tab of the majority of investment websites; some also display it on the stock summary tab.
Price to Book Ratio Example
It is an ABC company. The current share price of ABC company is ₹5. Here is some information about the ABC company.
Balance sheet for company ABC year ended on 31.03.2019.
| Particular | Amount |
|---|---|
| Non-current assets | |
| Fixed assets | 425,000 |
| Long term investments | 390,000 |
| Total non-current assets | 815,000 |
| Current assets | |
| Cash in hand | 20,000 |
| Bills receivable | 50,000 |
| Inventory | 250,000 |
| Prepaid expenses | 100,000 |
| Short term loans | 200,000 |
| Total current assets | 620,000 |
| Total assets | 14,35,000 |
| Equity | |
| Share capital | 600,000 |
| Reserve | 330,000 |
| Total equity | 930,000 |
| Non-current liabilities | |
| Debentures | 200,000 |
| Long-term loans | 150,000 |
| Total non-current liabilities | 350,000 |
| Current liabilities | |
| Bills payable | 50,000 |
| Overdraft | 100,000 |
| Short-term loans | 5,000 |
| Total current liabilities | 155,000 |
| Total equity and liabilities | 14,35,000 |
Book Value per Share = (₹14,35,000 - ₹5,05,000)/930,000
Book Value per Share = ₹1
Price to Book = ₹5 / ₹1 = 5
The price-to-book ratio is 5 means investors have to pay 5 times the book value to buy a share of the company.
Price to Book Value Interpretation
Normally, investors use the ratio to evaluate the valuation of a company. The price to book ratio shows whether the stock is trading at premium or discount.
This valuation ratio must not be taken into account in isolation, though. It is compatible with additional parameters. As seen below, a company with a low/high price to book ratio can be described.
A price-to-book ratio lower or less than 1 reveals the stock is undervalued. Hence the stock is trading at a lower price in relation to the value of a company's assets. As an investor, you must investigate why the market price of the shares is less than the book value.
A company's share price may be undervalued because a company has been facing losses or poor management investment decisions. Hence, intelligent investors should not pick a company just because their P/B ratio is less than 1 and consider it an undervalued stock.
A P/B ratio is higher or more than 1 indicating the stock is overvalued. Therefore, the shares are trading at a premium price because a company has healthy growth in the future and investors are willing to make more money for that possibility. There will be a good investment decision.
The price-to-book ratio indicates whether or not the value of its assets is comparable to the market price of its stock. It would be more useful when comparing companies within the same sectors or industries.
A high ROA is also a sign of a company's high share price. But this also suggests that the majority of the company's good news has already been included in the stock price. Consequently, the stock price may not be significantly affected by any good news or results.
This ratio offers a valuation check for investors looking for companies that will grow reasonably. Because it shows how much profit is made using the company's assets, this ratio is frequently employed alongside return on equity (ROE). A warning sign is any difference between ROE and P/B ratio. Furthermore, low ROE and a high P/B ratio are both characteristics of expensive equities. Therefore, the P/B ratio will increase if the company's ROE increases.
Limitations of Price to Book Ratio
It is important to note that the Interpretation and significance of the profit-to-book ratio differ from industry to industry.
Just one single metric does not apply across companies and industries. Hence standard metric must exist to enable comparison using the P/B ratio.
The P/B ratio is useful for insurance and financial-related firms(P/B ratio low). This ratio is not useful for a firm with assets in heavy industries such as the manufacturing industry, steel etc. Whereas technology & service industries(P/B ratio high) like information technology, online sector etc.
In the balance sheet, long-term assets are held at the real price. Those assets are written off every year which can affect the book value.
Because of this, some investors use different statistics in addition to the P/B ratio to assess whether a firm is overvalued or undervalued.
Return on Equity vs P/B Ratio
Return on equity evaluates how efficiently a company uses its shareholders' equity capital to generate net income. ROE is also called Return On Net Worth, which shows how efficiently management is using equity funds.
Along with the P/B ratio, it tells us about the growth prospects of a company's insight. Value investors often appreciate it when a company's ROE rises in step with its earnings-to-book value ratio.
Investors should be wary if a company's ROE and P/B ratio are not consistent. A high profit-to-book ratio and a low ROE typically indicate that a company is overvalued.
Although, the both P/B ratio and ROE are imperative and useful for the thorough analysis of stocks. Hence, investors should duly consider other metrics also before deciding whether a stock is worth investing in or not.
What is a good Price Book Ratio?
A good price-to-book ratio would depend on the industry and other factors Such as the valuation of the market and company too. An investor evaluating the price-to-book ratio of a stock may decide to accept a higher average price-to-book ratio.
In contrast to an investor looking at a company's stock in an industry where lower price-to-book ratios are the norm.
Higher price to book value also reflects the high growth potential and less price to book value means the company is not fundamentally strong. When the P/B ratio is more than 2, then you can buy the stock.
The Bottom Line
The P/B ratio does not give a holistic scenario about a company. It only indicates whether the company is undervalued or overvalued.
This ratio must also be evaluated in comparison to other companies in the same sector. Finally, combining this ratio with additional valuation indicators improves the analysis of choosing an investment stock.
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