Price to book ratio is a famous financial valuation tool used to evaluate whether the stock a company is over or undervalued by comparing the price of all outstanding shares with the net assets of the company.

what is P/B Ratio?

  • Price to book ratio is also called the P/B ratio, where Price is current market price of the stock and book is its book value per share.
  • P/B ratio compares the market value and book value of the comapny. This comparison demonstrates the difference between the market value and book value of a company.
  • A stock’s market value is a forward-looking metric that reflects a company’s future cash flows. The market value equals the current stock price of all outstanding shares. This is the price that the market thinks the company is worth.
  • The book value of a company is the value of a company’s net assets expressed on the balance sheet. It is the difference between the balance sheet assets and balance sheet liabilities. And it is an estimation of the value if the company liquidated its assets.
What is P/B Ratio?
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Formula : P/B RAtio

  • Mathematically, we can calculate P/B ratio simply dividing the current closing price of the share by the latest quarter’s book value per share.
  • P/B Ratio = [ Market Price per share / Book Value per share ] Where,
    • The Market Price per share = Current stock price that the company is being traded at on the open market.
    • The Book Value per share = [ Book value of company / Total No. of shares outstanding ]
    • Book Value of company = Net Assets of the company excluding intangible assets
  • Thus, Book Value of company = Total Assets – Intangible Assets –  Liabilities

Example

To explain the calculation part, consider an example of our largest bank SBI, which has INR 3454752.00 Cr in assets. It is the sum of all line items in the assets section of the balance sheet. Here the sum of cash, balances, investments, fixed assets and other assets. Also, we have INR 3235623.44 Cr in liabilities, which is the sum of current and non-current liabilities in the balance sheet. The book value of that company would be INR Rs 219128.56 Cr (Assets – Liabilities). Note that it is equal to the Owner’s equity, as per the fundamental balance sheet equation of Assets = liabilities + Equity. There are 8,924,587,534 shares outstanding, each share would represent INR 245.53 of book value. If each share sells on the market at INR 288.5 (as on March 11, 2019), then the P/B ratio would be = [ Current Market Price / Book Value per share ] = [288.5 / 245.53] = 1.18.

Balance Sheet of State Bank of India (values in INR Crores)

Balance Sheet of State Bank of India
Source : Moneycontrol.com
  • P/B ratio = Stock Price / Book Value per share
  • Book value = Rs 3,454,752.00 Cr–  Rs 3,235,623.44 Cr= Rs 219,128.56 Cr (note that this is the same as owners’ equity)
  • Book Value per Share = [ Rs 219,128,5600000 / 8,924,587,534 ] = INR 245.53
  • P/B Ratio = [ 288.5 / 245.53 ] = 1.18x

how to use p/b ratio?

  1. Investors express the price-to-book value ratio as a multiple showing ‘how many times a company’s stock is trading per share compared to the company’s book value per share’. Thus it is an indication of how much shareholders are paying for the net assets of a company.
  2. P/B ratio is especially useful when valuing companies that are composed of mostly liquid assets, such as finance, investment, insurance, and banking firms. It should not be used for those companies which have large R&D expenditure or firms with a large no. of fixed assets. This is because the fixed long term assets are reported at historical assets. If those historical prices vary a lot with the market prices, book value can differ dramatically from market value.
  3. The P/B ratio will not work well in the service sector. For example – IT and consulting companies where the primary assets are human resources, so for the, P/E is the right valuation multiple.
  4. P/B ratio is particularly useful for value investors, who are always behind the stocks trading below the intrinsic value.

Analysis of P/B ratio

  1. If P/B is less than one, it indicates that either the market believes the asset value is overstated, or the company is earning a very poor (even negative) return on its assets.
  2. A higher P/B ratio implies that investors expect management to create more value from a given set of assets, all else equal. Any additional good news may already be accounted for in the price and it may represent that the stock is overvalued.
  3. A lower P/B ratio could mean that the stock is undervalued. In fact, there can be two cases: either the market believes that the asset value is overstated, or the company is earning a very poor (even negative) return on its assets. So, it could also mean that something is fundamentally wrong with the company.
  4. Large discrepancies between P/B and ROE, a key growth indicator, can sometimes send up a red flag on companies. Because If a company’s ROE is growing, its P/B ratio should be doing the same. Overvalued growth stocks frequently show a combination of low ROE and high P/B ratios.

Limitations

  • The P/B ratio is mostly useful when you are looking at capital-intensive businesses or financial businesses, who have plenty of tangible assets on books. As for banks, most of the assets are recorded at market value. P/B has no use in sectors where there are very less tangible assets, as in the case of service sector.
  • Book value doesn’t really offer insight into companies that carry high debt levels or sustained losses, such as infrastructure companies. Debt can boost a company’s liabilities to the point where they wipe out much of the book value of its hard assets, creating artificially high P/B values.
  • This method doesn’t take dividends into consideration. Investors are almost always willing to pay more for shares that will regularly and reliability issue a dividend.

summary

  1. P/B ratio is a financial valuation tool used to evaluate whether the stock a company is over or undervalued by comparing the price of all outstanding shares with the net assets of the company. 
  2. As a conclusion, we can say that P/B is indeed an easy to use tool for identifying clearly under or overvalued companies.
  3. But, despite its simplicity, P/B doesn’t do magic. There are many other factors that this basic calculation doesn’t take into account. The real purpose of it is to give investors a rough idea as to whether the sale price is close to what it should be.
  4. We recommend that all investors should understand the advantages and disadvantages of the ratio in detail before using it for making investment decisions.