When you think of the greatest investors in the history of the stock market, names like Warren Buffett and Benjamin Graham come to mind- they are investors are proponents of “value Investing” and there is no metric more associated with value than the price-to-book ratio.
The price-to-book (P/B) ratio is widely associated with value investing because it is conventionally seen as an indicator of an undervalued company” where the market is not fully discounting the value of assets that a company has deployed to generate future earnings.
“Book value” is defined as the net asset value of a company, and is calculated by adding up total assets and subtracting liabilities. Book value per share is arrived at by dividing book value by the number of stock shares outstanding. This can be thought of as the amount that shareholders would theoretically receive per share of stock held if the company went out of business and all the assets were liquidated.
P/B ratio = market capitalization / book value of equity
(Market capitalization is often abbreviated as “market cap”; book value is often abbreviated as “BV”)
Market capitalization = shares outstanding * market price per share
Book value of equity = book value of assets – book value of liabilities
So therefore, P/B = market cap / (BV of assets – BV of liabilities)
The book values of assets and liabilities are easily found on the balance sheet OR one may see this on our Mobile App as well. Our India Strategy Reports apart from all our research reports (https://www.plindia.com/LatestReports.aspx) carry these as well.
Using this ratio
P/B is best used for asset-heavy companies, such as financial institutions, manufacturing companies, and other capital-intensive industries. In these cases, a lower-than-average P/B ratio compared with past years may indicate a value opportunity.
Generally speaking, a low P/B (especially if lesser than 1) can indicate that either the assets are overstated on the balance sheet or 2) that the that the industry at large has a low P/B or 3) that the price has suffered a major setback and may course correct as performance improves.
Some sectors and stocks have a general tendency to trade at relatively low P/BV level. Others have a history of trading at much higher P/BV levels. As a result, it is not always possible to look at a given company’s current P/BV and deem it “high” or “low.” Therefore, it is typically best to compare a company’s current P/BV to its own historical range in order to get some historical perspective.
One however needs to research a bit more as companies that have very long-lived assets like real estate on the balance sheet at original cost (i.e., the book value) will have understated assets and, therefore, an understated book value (remember, book value of equity = assets – liabilities), for instance. In this case, you might miss an undervalued company by simply looking for low P/B ratios.
Aggressive serial acquisitions will also tend to increase the book value and lower the P/B because the new assets go on the balance sheet at the full price paid. A serial acquirer of other companies will almost always have a high book value, which may artificially lower P/B. However, a huge part of the book value will be in goodwill or intangiblesand it would be practical to subtract goodwill from book value, resulting in a “tangible book value to derive the P/B.
The Value Trap
Sometimes when there is a significant change to the underlying business model the stock may not be undervalued any more- This situation is often referred to as a “value trap”, where a company appears to be undervalued but is reality investors have simply not yet recognized the underlying negative change in the company’s fundamentals.
Similarly, when the P/BV for a stock reaches a significantly higher level than the stock has experienced in the past it may signal over-exuberance and can serve as a warning sign that the stock is in extreme territory. Still, remember that just because a stock trades at a higher than historical P/BV does not necessarily mean that it won’t continue to advance as it may also imply that investors anticipate strong earnings growth as compared to the rest of the industry.
So it can also be helpful to compare a given company’s current P/BV to that of the average P/BV for stocks in the same industry group. And in addition, add more metrics to that like the one below.
P/B and ROE
In order to use the P/BV ratio to assess how overvalued or undervalued a stock may be, you must compare the current P/BV with something else apart from the historical P/BV of the company and the P/BV ratios of peers in the industry.
ROE is the most useful companion metric for P/B. A high ROE normally accompanies a high P/B ratio because investors naturally bid up the price of a company that gives them a better return on their equity. Similarly, companies that have high earnings growth rates generally have high P/B ratios — investors expect the book value of equity per share to grow.
However, if a high-growth company has a high P/B ratio and low ROE, that growth may not be translating into shareholder value. This could portend a collapse in share price.