Continuing in the fundamental analysis series, we are now going to take a look at the Price to Book Ratio, what it is, and how it might be helpful in evaluating an investment.
The Price to Book Ratio (P / B Ratio), less commonly referred to as the Price-Equity Ratio, is one of the most widely used financial metrics in fundamental analysis.
In plain terms, it’s how the market is valuing the company compared to its net worth.
So you can multiply the share price by the number of outstanding shares and compare that to the overall net worth of the company, or you can take the share price and divide it by the net worth of the company per share.
For instance, if Company XYZ had $ 20 million in net worth (assets minus liabilities) and 1 million shares outstanding, that would be a “book value” of $ 20 per share.
If shares of XYZ were selling on the market for $ 50, then the P / B ratio would be 2.5, or $ 2.50 for every $ 1 of net worth.
Another way of calculating it would be to take the market price per share and multiply it by the number of shares, then divide by the net worth.
In this example, that would be $ 50 per share, times 1 million shares, equals $ 50 million. $ 50 Million divided by $ 20 Million = 2.5, the same answer we got earlier.
The Price to Book Ratio is a way of trying to estimate whether a company is overvalued or undervalued.
It’s a forward looking metric that is quite frequently greater than 1, usually indicating the market’s belief that the company is growing.
Values less than 1 could indicate that a company is undervalued, but may also be an indication that something is wrong fundamentally with the company.
As with many other fundamental metrics we have looked at, ratios can vary by industry and often are not as valuable by themselves.
One would normally pair the P / B ratio with another indicator – say a growth indicator like return on equity (ROE) – to gain better insight.
Further investigation is not a bad idea if one is uncertain what any indicator might be saying.
Value investors may consider ratios between 1 and 3 as a benchmark for any stocks they might be looking to own.
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In a word, yes. However, less clear is exactly where that line is drawn. What may be considered “good” in one industry may be “poor” in another.
Likewise, individual investors may have their own thresholds for what they consider a “good” ratio.
For example, a company may have intangible assets, such as patents or other intellectual property.
These are assets and are used in calculating the P / B ratio, but are often subjective in nature to their “value”.
(For those curious, there is another closely related metric called the Price to Tangible Book Value [PTBV] that only considers tangible assets in the calculation.
Service and technology companies will typically have much smaller PTBV ratios since they frequently have more intangible assets when compared to companies, say, in manufacturing.)
As much as we may want it to be the case, unfortunately, not all firms abide by the same accounting standards.
Therefore, P / B ratios may not be comparable, even within the same industry, and especially with companies from different countries.
Additionally, scenarios such as recent acquisitions, write-offs, or buybacks can otherwise skew the book value used in the calculation.
As much as possible, you want to use book values that were derived in the same way.
Despite some inconsistencies with Price to Book Ratios, it remains an important metric in fundamental analysis.
It can help an investor to determine, at least individually, whether or not the market price of a company seems reasonable when compared to its balance sheet.
Just because a ratio is high, doesn’t mean that the company is necessarily overvalued.
Likewise, a low ratio doesn’t necessarily mean the company is undervalued.
However, one could use the P / B ratio to screen for potential investment opportunities and use other measures to determine whether or not that valuation is justified.
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.