It’s only one data point, but when used in the right context it can be very revealing
What Is Price-to-Book Ratio?
The Price-to-Book (P/B) Ratio is a financial ratio that compares a company’s Book Value to its current market value. The P/B ratio identifies the portion of a company that is held by its shareholders.
The formula for P/B ratio is:
Market Capitalization/Current Book Value of Equity
The company’s market capitalization is usually readily available. However, it can be calculated by multiplying the current stock price by the number of diluted shares outstanding. A company’s book value (tangible net asset value) is the company’s assets minus its total liabilities which may include intangible assets (e.g. patents, goodwill). This is gleaned from a company’s financial statements which most companies issue quarterly.
What is the Purpose of the Price-to-Book Ratio?
The P/B ratio (which is less commonly known as the price-equity ratio) is only one of many measures that value investors may use to make an investment decision. The specific purpose of the P/B ratio is to give a sense of the company’s valuation.
Even more specifically, the P/B ratio attempts to answer the question: “Am I paying too much for what would remain of this company if it went bankrupt?” If a company goes into bankruptcy it would have to liquidate all of its assets and pay off its debt. Whatever value is left over would be the company’s book value. In that context, the P/B ratio lets investors see if they are getting growth at a reasonable price.
In general, a stock with a low P/B ratio (around 1) suggests the stock is undervalued. However, there are many other things to consider. For example, if a company is in an emerging sector, its price-to-book ratio will likely be much higher. And for low-growth companies, such as utilities, a P/B ratio that is too low could suggest the company has other financial problems.
Is the Price-to-Book Ratio a Standalone Indicator?
The P/B ratio is just one data point for value investors to use. Frequently it is compared to a company’s return on equity (ROE), which is a reliable indicator of growth. Ideally, value investors are looking for these two numbers to show a decent correlation. That is, if a company’s return on equity is growing, its P/B ratio should be growing. When a company shows a low ROE and a high P/B ratio it is almost always a sign that a stock is overvalued.
What is a Good Price-to-Book Ratio?
As noted above, in general a “good” P/B ratio is considered to be anything under 1.0. That is universally seen as a sign that a stock is undervalued. Benjamin Graham who is considered to be the “father of value investing” believed that value investors should not invest in any stock with a P/B ratio above 1.5. It’s safe to say that the stock market of today is very different than the one that Graham knew. And today, many investors regard any number under 3.0 to be a good price-to-book ratio.
However, an important concept to remember about the Price-to-Book ratio is that proper analysis of what makes a good or bad P/B ratio can depend on the industry or sector. For example, let’s look at the P/B rations for two companies in the semiconductor sector: Advanced Micro Devices (NASDAQ:AMD) and Intel (NASDAQ:INTC).
At the time of this writing, AMD checks in with a P/B ratio of 20.11. That’s much higher than the sector average of 3.58. INTC has a P/B ratio of just 1.95. While that is a bit higher than what some analysts would want, it’s far below the P/B ratio of a competitor in the sector. It’s also below the sector average.
At first glance that would make Intel the better option. And the reality is it will be a better option for value investors. Intel is a mature company that is reflected in the fact that it pays a dividend. However, growth investors are far more likely to choose AMD which is a company that is still in growth mode. With that in mind, growth investors are more likely to ignore the P/B ratio altogether.
What Are the Advantages of the Price/Book Ratio?
Compared to other valuation metrics, the P/B ratio has several advantages. First, a company’s book value is generally positive even if the price-to-earnings (P/E) ratio is negative – meaning the company is not profitable. In cases like these, P/B ratio can be used as a proxy of sorts. Second, a company’s P/B ratio tends to be less volatile than P/E ratio.
What Are the Disadvantages of the Price/Book Ratio?
The P/B ratio has to be viewed in context. By itself a low P/B ratio does not mean a stock is undervalued. In fact, it can suggest that a company is having financial trouble. Conversely, a high P/B ratio does not necessarily mean a stock is a poor choice for value investors as it reflects a moment in time.
The P/B ratio only covers tangible assets. However, companies have intangible assets that should rightly be considered in assessing a company’s value. For example, companies such as Starbucks (NASDAQ:SBUX) and Amazon (NASDAQ:AMZN) have strong brand value that is not accounted for. Also, the P/B ratio cannot properly value the human capital that is found in many service companies.
At first glance, P/B ratio does not account for different production methods that may change the value of assets. Similarly, inflation and technology can have a significant effect on the book and market value of assets. Also, investors have to know what accounting method is being used (GAAP, non-GAAP, IFRS) because that will cause asset values to be different.
Some Final Thoughts on Price-to-Book Ratio
When making any investment, investors have to hope for the best but plan for the worst. The P/B ratio is a metric that shows the relationship between a company’s market capitalization and its book value. A company’s market capitalization defines the price that investors believe the company’s equity is worth. The book value is the value of the assets that shareholders would get if the company went bankrupt.
Since the value that investors put on equity can be different than the book value, the P/B ratio gives value investors a reality check. For that same reason, growth investors usually do not put much emphasis on P/B ratio because frequently companies that are showing strong growth will have a high P/B ratio.7 Travel Stocks That Will Benefit as Covid Restrictions End
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