The price-to-book (P/B) ratio is the ratio of a company's market value to its value according to its financial statements. Investors commonly use the metric to evaluate and compare shares.
For example, suppose you were comparing two similar companies in the same industry with the same growth prospects. In that case, you might utilise their respective PB ratios to determine which one looks to be better value.
Let's take a look.
How does the price-to-book (P/B) ratio work?
Price-to-book (P/B) ratio compares a company's share price to its book value per share. A company's book value is how much it is worth, according to its financial statements.
Book value is calculated by subtracting the total value of a company's liabilities from the total value of its assets. Book value is objective and calculated using historical financial data.
This means it is generally considered a fair and accurate calculation of a company's worth at a point in time. Many companies, however, are valued by shareholders more than the value of their assets alone. Intangible factors can add to the value of a company meaning its market capitalisation exceeds the value of its assets, sometimes substantially so.
Investors use P/B ratios to compare shares and identify undervalued shares. Generally, the market value of a company's equity is higher than its book value. A lower P/B ratio can indicate that a share is undervalued relative to its peers.
On the other hand, care must be exercised using P/B ratios, as they can be of limited value in isolation. P/B ratios tend to vary across industries and can be more helpful for assessing some types of businesses than others.
Certain businesses (such as software companies) tend to trade at relatively high P/B ratios as a high proportion of their assets are intangible. Hence P/B ratios may be of greater utilisation when evaluating companies in capital-intensive industries.
How do you calculate it?
The P/B ratio is calculated by dividing the share price by the book value per share, per the below formula:
P/B ratio = Market price per share / Book value per share
For example, if a share is trading for $12, and the book value per share is $10, the P/B ratio will be 12/10 = 1.2.
You can determine the market price for a share by checking what it is currently trading for on the ASX. To determine the book value, you will need to look at the company's most recent financial statements.
The book value will be the value of the company's assets minus its liabilities. To figure out the book value per share, you need to divide the book value by the number of shares on issue.
When do we use the P/B ratio?
Investors use the P/B ratio to evaluate the value of companies, given their current share price. It is a metric that can indicate whether a stock is 'good value' at its current share price. If the P/B ratio is low, this may suggest the market is undervaluing a company.
If the P/B ratio is high, it may indicate that a company is overvalued. But caution must be exercised when using P/B ratios — they tend to differ across sectors and offer limited insight when used in isolation.
They can, however, be helpful as a screening tool and in comparing similar companies operating in similar industries. The P/B ratio is best used with a broader evaluation of potential share investments. Investors often use it alongside profitability indicators such as return on equity (ROE).
What is a good P/B ratio?
What constitutes a 'good' P/B ratio depends on perspective, but generally, a ratio less than one means the company is trading at less than its book value, hence may be undervalued.
If the P/B ratio is one, it means the share price is in line with the company's book value. This tends to indicate that a share is fairly valued.
Where the P/B ratio is above one, shares are trading at a premium to the book value, indicating they are overvalued. It is worth noting, however, that the share market can often value equity at more than its book value. This means P/B ratios of as much as three or more may represent good value to a value investor.
What is a good P/B ratio also depends on the type of business a company is operating. A good P/B ratio for one industry may not be for another.
A high P/B ratio indicates investors value a company's shares more than the value of its assets. This could be because the company is in an industry that relies on human capital or has a high return on assets. Equally, it may indicate that the company is overvalued.
Value investors look for shares with lower P/B ratios as this indicates a company may be trading for less than it is worth.
Any drawbacks to using the P/B ratio?
The P/B ratio of a company should not be considered in isolation. It can be helpful when used alongside other metrics and investigations, bearing in mind that specific industries are more capital-intensive than others.
P/B ratios are generally of greater use when compared across similar companies in the same industry. Some sectors may have higher P/B ratios, while others may tend towards lower ratios.
P/B ratios are also necessarily tied to book value, a point-in-time measure. The value of a company's assets and liabilities will fluctuate daily but are only tallied and reported at the end of financial reporting periods.
This means the book value of a share today may differ from what was reported in its previous financial results. Accounting standards can also vary across industries, companies, and jurisdictions. This means P/B ratios may not necessarily provide a like-for-like comparison.
Why should you use this metric?
P/B ratios can be a helpful screening and comparison metric when used in conjunction with other investigations. Analysts widely use the ratio, and it is favoured by value investors searching for undervalued shares.
Investors should exercise caution when relying on P/B ratios, as they are best used in conjunction with in-depth analysis to make like-for-like comparisons. The P/B ratio tells you how the market values a company relative to the value of its assets. But many companies are worth more than the assets they own.
This means it is difficult to determine what a standard ratio should be – it varies depending on the business. Provided P/B ratios are utilised with these factors in mind, they can be a useful analytical tool for investors.
