What is Price to Book Value Ratio (P/B Ratio)?
The price to book value ratio or also known as the P/B ratio is the direct comparison between a company’s market capitalization with its book value.
The price to book value ratio can be calculated by dividing the market price of the company’s share by the book value per share of the company. It is one of the best fundamental analysis tools for equity analysts.
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Formula and Calculation P/B Ratio
One can calculate the price to book value ratio or P/B ratio by dividing the current stock price by the book value per share of the company.
Price to Book value ratio (P/B ratio) = Stock Price/Book value per share
Let assume a company’s current stock price is $50 and the per-share book value is $10. So what will be its price to book value ratio?
P/B Ratio = $50/$10 = 5 So Price to Book value ration of the company is 5, which means the company is trading at 5 multiple of its book value.
What Does The P/B Ratio Tell About A Stock?
Price to book ratio is used for the determination of the market valuation of a company relative to its book value. This ratio gives an idea about, what will leave if a company goes bankrupt immediately and how much investors are will get.
High P/B Ratio
High P/B ratio indicates that the investors are willing to pay a premium above the book value and they are expecting that the company will generate enough earnings in the future.
The high P/B ratio tells that the company’s stock price is overvalued and some times overvalued stock can generate some huge losses because they are unpredictable.
Sometimes the company’s book value is not updated so as their balance sheet, so in that case, the P/B ratio may seem higher, but they are actually not.
Low P/B Ratio
Low P/B ratio usually less the 1, indicates that the stock is trading at a lower valuation, but some times that’s not the case. Investors also think that the company’s balance sheet is inflated and not worth the book value so they are trading at a negative value.
If a company’s stock is trading less than its book value (P/B ratio less than 1), it may indicate the investors one of two things; either the investors in the market believe the asset value is inflated or overstated, or the company’s earning a very poor or return on its assets is very low.
Some times stocks with good fundamentals, but trading with a lower price to book value ratio because of some bear market or other corporate issues may be generating good income for the investors in the future.
Importance of P/B Ratio
- P/B ratio is an important tool to find out if a stock is overvalued or undervalued.
- P/B ratio gives a better understanding of a company’s book value and future growth prospects.
- In combination with financial ratios like the P/E ratio, ROE the price to book value ratio works well for fundamental analysis.
- When majoring in a company’s valuation, the PE ratio is the most commonly used fundamental analysis tool.
Limitation of P/B Ratio
- P/B ratio is important mainly in capital intensive business those who have plenty of assets (Like plant machinery, Land) and do not carry much meaning in service-oriented industries.
- Sometime debt-ridden companies with sustained losses where the major portion of its book value wiped out artificially show a higher P/B ratio, that confuses the investors.
P/B ratio mostly remains as a tried and tested method for finding out the low-priced stocks, that the market has neglected. It is very easy to use tool and popular because of its relationship with the stock’s price.