A number of different metrics are used to determine if a stock should be purchased or not. The price to book ratio is one such value. It is basically the amount an investor will get (per share) if the company goes bankrupt or is liquidated. It is also used to determine if a firm is undervalued or overvalued.
This ratio compares the market value of a stock to its book value. Let's first understand what is market value and book value.
Market value refers to the company’s market capitalisation. It is calculated by multiplying the share price of a firm with its outstanding shares.
Meanwhile, the book value refers to the amount shareholders will receive if it is suddenly shut down or liquidated with no liabilities. It is calculated by subtracting the total liabilities from the total assets of the company. It is disclosed in the balance sheet of the company every quarter.
How is the P/B ratio calculated?
There are 2 formulas to calculate the P/B Ratio.
1) P/B Ratio = Current share price/ book value per share
2) P/B ratio = Market capitalisation / Book value of assets
The current share price and market capitalisations are available on the exchanges.
Book value of assets = Total assets - total liabilities
Book Value per Share = (Total Assets – Total Liabilities) / Number of outstanding shares
Let’s understand with an example.
Suppose a firm has assets worth ₹100 crore and liabilities worth ₹25 crore. Then the book value of assets of the company will be 100 crore - 25 crore = ₹75 crore.
Now let's suppose the firm has 1 crore outstanding shares. So the book value per share will come out to be ₹75 crore divided by 1 crore = 75
Now say, the current share price of the firm is ₹100. Then the P/B ratio will be 100/75 = 1.33
What does the P/B ratio indicate?
P/B ratio generally indicates whether the stock is worth how much the investor is paying and how much will the investor get if it goes bankrupt.
If the P/B ratio of a stock is lower, then it indicates that the stock is undervalued and vice versa. A low P/B ratio can indicate some fundamental problems with the firm like high debt, fewer assets, etc.
Value investors generally use this ratio to decide whether to invest in a particular stock or not. They look for stocks whose P/B ratio is less, which means it is undervalued by the market. However, they analyse the fundamentals of the firm to make sure they are sound, indicating a strong growth potential in the future.
Usually, a P/B ratio of less than 1 shows an undervalued stock. However, it depends from sector to sector. Meanwhile, a P/B ratio of 1 indicates that a stock is fairly valued.
A P/B ratio of over 3 showcases that the stock is overvalued and may fall in the near future. This showcases the stock is trading at 3 times its book value and thus helps investors avoid such firms.
In the case of negative earnings, the price-to-earnings ratio will not be reliable, so the price-to-book ratio will be preferred more by the investors.
P/B ratios are generally used in combination with RoE (return on equity). If the P/B ratio is steadily rising so should the RoE. A large difference between RoE and P/B ratio can be seen as a red flag. An overvalued firm will have a high P/B ratio but a low RoE.
How accurate is it?
It is important to note that while comparing P/B ratios of 2 stocks, it is important that the sectors are the same. Different sectors will have a different value of a 'good P/B ratio".
For example, in an IT firm, a P/B ratio of less than 1 can be seen as an undervalued stock which is a positive since they have intangible assets like intellectual property which cannot be valued.
However, the same will be a negative for an oil and gas firm as it has more tangible assets and hence its value is more clearly reflected by a P/B ratio. So it is important not to compare apples to oranges as it will not be a correct comparison.
Now that we clearly understand the P/B ratio, we can use it to identify undervalued firms and avoid overvalued firms.