What is it?
A Price-to-Book (P/B) ratio is a financial metric used to compare a company’s market price to its book value. It shows whether the company’s stock price is undervalued or overvalued.
Components
There are 2 components needed to calculate the P/B ratio. They are:
- Market value
- Book value
The market value (MV) refers to the market capitalization of the company. You can calculate it by multiplying the number of shares with its share price.
The book value (BV) refers to the net assets of the company. This means it is the value of the company after it has sold all of its assets and paid off all of its liabilities. You can calculate it by subtracting a company’s total assets minus its intangible assets and liabilities.
Formula
You can calculate the P/B ratio using the following formulas below. Both will result in the same result.
P/B ratio = market price / book value
P/B ratio = market price per share / book value per share
The market price per share is the share price listed on the ASX whereas the book value per share is the total assets minus total liabilities divided by the number of shares.
Example
Qantas has a market price per share of 6.18 AUD and a book value per share of 2.14 AUD. This means that its P/B ratio is 2.89. We get this number by dividing the market price per share with its book value per share.
All of these information’s are provided already on the ASX website, but it is important for you to understand the components to know what the ratios mean.
What the ratios mean
Essentially, P/B ratio reflects the value that market participants attach to the company’s equity relative to its book value equity. This means that investors use this ratio to compare the true value of the company (book value) and investor speculation (market value). This is mainly because market value is driven by how the investors speculate the company will perform whereas the book value is the net assets of the company, how much it is actually worth.
Generally, if a P/B ratio is above 1, it indicates that investors are willing to pay more than its actually worth. This may be because investors think the company has healthy financial prospects but it also may mean that a company is overvalued. If a P/B ratio is below, it indicates that the company’s share price is selling for less than its actually worth which This means that the company is undervalued.
Limitations
Relevant only to capital-intensive companies
Accounting principles do not recognize intangible assets such as goodwill, patents, brand awareness, intellectual capital, etc. This means that the book value of a company does not take into account these variables. As a result, the P/B ratio is useless for companies such as Google, Facebook, Microsoft, Apple, etc. This is because most of these tech company’s intangible assets are worth more than their assets in the balance sheet. You can find out about intangible assets here.
On the other hand, the ratio is relevant to companies that has lots of investments in tangible assets.
Different accounting standards
The purpose of a P/B ratio is to determine whether a company is undervalued or overvalued relative to its industry players. As a result, this means that if the company uses different accounting standards, this means that the book value and subsequent P/B ratio will not be comparable.
Conclusion
Stock prices tend to increase based on how much people are willing to pay. This depends on what people think the company will do in the future. As a result, some stock prices can be said to be artificially inflated. The P/B ratio allows you to compare the actual value of the company with how much people think the company is worth. Subsequently, if you want further advice on how the P/B ratio works, it is worth speaking to a business lawyer.
