Price to Book Ratio – Meaning, formula, and how to use?

The fundamental analysis of a company is a systematic approach to evaluating its financial statements and key ratios to understand its relative performance. These parameters are then compared with the company’s past performance and also the performance of its peers within the industry. All this goes into determining key investment and strategic decisions. Among the key valuation ratios of the fundamental analysis is the Price to Book ratio, which is often used by value investors in their decision-making process. Read this blog to know the true meaning of price to book ratio and its interpretation to create a stronger investment portfolio. 

Read More: What is Price to Earnings ratio?

What is Price to Book ratio?

The Price to Book (P/B) ratio is a financial metric that helps investors evaluate the intrinsic value of a company’s stock. It compares the price per share of a company’s stock to its book value per share. This is a valuation ratio that is used to determine if a stock is undervalued, overvalued, or fairly priced.

 It is also referred to as the Market to Book Ratio or Price to Equity Ratio (P/E ratio) and compares a company’s market capitalization to its book value, which is the net asset value (book value of its assets minus liabilities). The P/B ratio is particularly useful for evaluating companies in industries where assets play a significant role, such as banking or manufacturing. The P/B ratio helps investors assess whether they are paying a premium or getting a discount on a stock.

What is the formula for calculating the Price to Book ratio?

The formula for calculating the Price to Book (P/B) ratio is,

Price to Book Value = Market Capitalisation / Book Value of Assets

Or

P/B ratio = Market Price per Share / Book Value per Share

Alternatively, investors can calculate the book value per share through the balance sheet of a company and by calculating the net assets. The formula for the same is 

Book Value per Share Formula = (Total Assets – Total Liabilities) / No. of outstanding shares

Let us understand the calculation of the Price to book ratio using the following example. 

Suppose an investor is interested in a company called XYZ Ltd. The market price of one share of XYZ Ltd’s stock is Rs. 200, and the book value per share is Rs. 50.

To calculate the P/B ratio, the market price per share (Rs. 200) is divided by the book value per share (Rs. 50).

P/B ratio = Market Price per Share / Book Value per Share

P/B ratio = 200 / 50

P/B ratio = 4

So, in this example, the P/B ratio for XYZ Ltd is 4. It means investors are willing to pay 4 times the book value per share for the company’s stock.

What is the interpretation of the Price to Book ratio and how to use it?

The value derived using the Price to book ratio is used to determine if the stock is undervalued, overvalued, or fairly priced in relation to its book value. The interpretation of the price-to-book value formula is given below.

High P/B ratio

If a company has a high P/B ratio (greater than 1), it suggests that investors are willing to pay a premium for each unit of the company’s net worth. This may indicate that the stock is overvalued. In such cases, it’s important to analyse the company’s growth prospects, profitability, and other factors to assess whether the premium is justified.

Low P/B ratio

Conversely, if a company has a low P/B ratio (less than 1), it indicates that the stock is trading at a price lower than its book value per share. This may suggest that the stock is undervalued. It could be an opportunity for investors to consider buying the stock at a potentially attractive price.

The P/B ratio has to be compared with that of the peer companies in the same industry for its effective use and understanding and efficient investment decisions.

What is an ideal Price to Book ratio?

It is not advisable to directly compare companies from different sectors solely based on the Price to Book (P/B) ratio. The ideal P/B ratio can vary for different sectors due to varying industry dynamics and accounting practices. 

However, in a conventional sense, a P/B ratio less than 1 is considered good as it suggests that the stock may be undervalued. This indicates that the accounting value of the company’s assets if sold, would be higher than its current market price. It implies that investors may be able to acquire the company’s assets at a lower price than their recorded value.

Additionally, a P/B ratio of less than 3 is generally preferred by value investors. This range signifies that the market price is within a reasonable range relative to the company’s book value. It suggests that investors are not paying a significant premium for the company’s net assets. 

What are the limitations of using the Price to Book ratio?

Price to book is a very commonly used financial ratio, however, it is not free of any limitations. A few key limitations of using the price to book ratio are highlighted below.

• The P/B ratio only considers tangible assets and does not account for intangible assets like brand value, patents, or intellectual property. Companies with significant intangible assets may have higher valuations than what the P/B ratio suggests.
• Different companies may use different accounting methods, resulting in variations in book values making it difficult to compare P/B ratios across companies, especially in the case of different industries or countries.
• This ratio does not consider a company’s future growth potential or its ability to generate future earnings. A company with high growth prospects may have a higher valuation than what the P/B ratio suggests.
• P/B ratio does not account for a company’s debt obligations. A company with high debt levels may have a lower book value due to interest expenses, which could distort the P/B ratio.
• The book value is based on the historical costs of assets and does not reflect their current market value. Therefore, the P/B ratio may not capture the true economic value of the company’s assets.
• Market sentiment and investor perception can heavily influence stock prices and distort the P/B ratio. Sometimes, stocks may be overvalued or undervalued due to factors unrelated to their book value.

Conclusion

The PB ratio is among the many valuation ratios of fundamental analysis that are used by new investors as well as experts to analyse a company and its position in the market. This ratio is easy to calculate and it helps investors understand the overbought or oversold position of the stock while setting up their portfolio.

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