What is Price-to-Book Ratio? How Can It Help in Stock Selection?

When buying a product, you evaluate multiple factors. Is it necessary? Is it worth the price? Will you be better off spending the money on something else? This helps you make an informed decision about the product’s value and whether or not it is worth the purchase. 

Similarly, investors also check the key financial metrics of a particular share to determine whether investing in it is worth the risk and if it will generate the desired returns.

One such metric is the price-to-book ratio (P/B ratio). It helps you determine if a stock is undervalued or overvalued based on its market price and book value.

Read on to learn what is P/B ratio of a stock and how it can help you make informed investment decisions.

What is the price-to-book ratio?

The price-to-book ratio is among the many metrics investors use to identify undervalued companies. In simple terms, it is the ratio of the market value of a company to its book value.

Here, market value refers to the price at which the share is currently trading in the financial market, whereas the book value is the value of the company’s assets in its financial statements. The P/B ratio helps you determine if a company’s stock is cheap or expensive compared to its total assets.

Calculation of the price-to-book ratio

Calculating the P/B ratio is very straightforward. All you need are the following details:

Market price: The price at which the share is currently trading in the stock market

Total outstanding shares: Total number of shares released by the company in the stock market

Total assets: The monetary value of the total asset of the company

Total liabilities: The monetary value of the total liabilities of the company

Now, you can easily calculate the P/B ratio using this formula:

P/B ratio = Market price/Book value

Where Book value = Total asset - Total liabilities

To better understand the calculation, let us take the example of company XYZ with the following data:

Book value per share = (Book value/Number of outstanding shares) = 20000/100 = Rs. 200

P/B ratio = 100/200 = 0.5

So, according to the given data, the price-to-book ratio of XYZ shares is 0.5.

What is a good price-to-book ratio?

A P/B ratio of 1 or less is typically considered good. Here’s a table to understand what does the price-to-book ratio mean:

Note: Even if the price-to-book ratio of a stock is below 1, you should not make hasty decisions. The P/B ratio should be one of the many metrics to consider before investing.

Significance of price-to-book ratio

Warren Buffett, one of the most prominent investors, believes in value investing, where you look for companies whose intrinsic value (book value) is less than the market value.

One of the best ways to identify such companies is through the price-to-book ratio. You can benefit from the price-to-book ratio in the following ways:

1. Share price valuation: The price-to-book ratio of a share helps you determine if it is undervalued or overvalued. By understanding what is a high price-to-book ratio, you can filter out overvalued shares and opt for financially sound ones that are currently undervalued.

2. Company assets and liabilities: A company’s price-to-book ratio gives you a better insight into its tangible assets and liabilities. For companies like real estate, where most of the assets are physical, these insights help you assess the company’s financial situation. It is typically recommended to avoid companies with more liabilities than assets.

3. Sector-based comparison: TheP/B ratio can be a crucial metric for comparing companies in a particular sector or industry. By comparing the price-to-book ratio of a specific share with its peers and sector average, you can decide whether or not a company’s valuation is worth investing in.   

4. Indication of market sentiment: By comparing the price-to-book ratio of a share with its historical average or industry average, you can determine its market sentiment. A constantly increasing P/B ratio shows an increase in investors’ confidence, while a decreasing P/B ratio shows the opposite.

Limitations of the price-to-book ratio

Like most financial tools available to investors, the price-to-book ratio also has certain limitations.

1. Intangible assets: P/B ratio calculations only consider a company’s tangible or physical assets. Such estimates work for industries like real estate, where most companies have physical assets. However, in the case of IT and pharma companies, where most of the assets are intangible, the price-to-book ratio cannot provide accurate insight into their valuation.

2. Debt: Another critical aspect that the price-to-book ratio fails to recognize is the debt borne by a company. As a result, even with a low price-to-book ratio, a company might be buried in debt, making it unfit for investment.

3. Cyclical businesses: Certain businesses are cyclical in nature. Their market values fluctuate between highs and lows at different times of the year. For example, specific industries, like commodities, may have a higher market price at one point of the year and lower at another time. This fluctuation also alters the price-to-book ratio, which might not portray an accurate picture of the company. 

4. Future prospect: With a P/B ratio, an investor can only glance at the company’s financials and past performance. However, it cannot predict if the company has the potential to do well in the future. This is why investors are often advised not to make decisions solely based on the price-to-book ratio.

Parting thoughts

The price-to-book ratio is a popular and vital financial tool that helps an investor measure the valuation of a company. When coupled with other tools for financial research, the P/B ratio can provide valuable insights and help you make informed decisions about your next investments.

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