Investors can use various ratios to calculate the value of their investments. Each of them illustrates a different aspect of the investment, which can help investors in their decision-making. Among these, one ratio is the price-to-book (P/B) ratio.
What is the Price-to-Book Ratio?
The price-to-book ratio is a comparison of the market value of the stocks of a company with its book value. The market value of the stocks is usually available in the stock market, while a company's book value is available in its financial statements. The book value of a company is the residual amount that is left when it repays all its liabilities from its assets.
The P/B ratio is one of the favourite metrics of investors because it allows them to determine whether the stock of a company is undervalued. Similarly, it can help them identify overvalued stocks so they can avoid investing in them. Based on the ratio, investors can make decisions about their portfolios.
How to calculate the Price-to-Book Ratio of a stock?
Calculating the P/B ratio of a stock is straightforward. Investors can use the formula below to calculate it.
Price-to-book ratio = Price per share of stock / Book value of company per share
For public-listed companies, investors can obtain the market value per share of its stock from the stock exchange. For private companies, it may be difficult to determine the exact price. Similarly, they can calculate the book value of the company per share of a company by dividing its shareholders' equity by its total number of outstanding shares.
What does the Price-to-Book Ratio signify?
Based on every stock, the P/B ratio calculated by investors will be different. Firstly, a P/B ratio of one signifies that the value of the stock of the company is in line with its book value. In other words, it means the market value of the stock reflects the book value of the company. However, instances, where the P/B ratio of a stock is one, are rare.
A P/B ratio that is greater than one means that the stock of the company is trading at a premium. Furthermore, it means the stock is overvalued. These are stocks that investors try to avoid as they may not provide returns in the future. In fact, they may result in losses when the market value of the stock settles down.
A P/B ratio of lower than one is what investors try to look for. It signifies a stock that is undervalued or operating at a discount. These stocks represent a profit opportunity for investors. Sometimes, however, a P/B ratio below one may also signify a company with overstated assets value. Similarly, a low P/B ratio can also be an indicator of poor financial performance.
Example
A company, Fox Co., has total assets of $20 million and total liabilities of $15 million. Its total outstanding number of shares is 400,000. The market value of its stock in the stock market is $10 per share. Its P/B ratio is as follows.
Price-to-book ratio = Price per share of stock / Book value of company per share
Price-to-book ratio = $10 / [($20 million - $15 million) / 400,000 shares]
Price-to-book ratio = 0.8
Conclusion
Investors use the Price-to-Book ratio of a stock to determine whether it is overpriced or underpriced. Based on the P/B ratio, they can make decisions regarding the investments. Usually, investors prefer it to be lower than one. Sometimes, however, it may also indicate other problems with the stock or the company.
Originally Published Here: Price to Book Ratio
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