What price should you pay for a company's shares? If the goal is to unearth high-growth companies selling at low-growth prices, the price-to-book ratio (P/B) offers investors a handy, albeit fairly crude, approach to finding undervalued companies. It is, however, important to understand exactly what the ratio can tell you and when it may not be an appropriate measurement tool.
What is 'Price-To-Book Ratio - P/B Ratio' ?
The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's current market price to its book value. The price-to-book value ratio, expressed as a multiple (i.e. how many times a company's stock is trading per share compared to the company's book value per share), is an indication of how much shareholders are paying for the net assets of a company.
The book value of a company is the value of a company's assets expressed on the balance sheet. It is the difference between the balance sheet assets and balance sheet liabilities and is an estimation of the value if it were to be liquidated.
Calculation
The calculation can be performed in two ways, but the result should be the same each way.
1. The company's market capitalization can be divided by the company's total book value from its balance sheet.
2. Divide the company's current share price by the book value per share (i.e. its book value divided by the number of outstanding shares).
Example
Assume a company has INR 100 million in assets and INR 75 million in liabilities. The book value of that company would be INR 25 million. If there are 1 million shares outstanding, each share would represent INR 25 of book value.
If each share sells on the market at INR 75, then the P/B ratio would be 3 (75/25).
What is it Significance ?
· A higher P/B ratio implies that investors expect management to create more value from a given set of assets, all else equal
· P/B ratios are commonly used to compare banks, because most assets and liabilities of banks are constantly valued at market values.
· Large discrepancies between P/B and ROE, a key growth indicator, can sometimes send up a red flag on companies. Overvalued growth stocks frequently show a combination of low ROE and high P/B ratios. If a company's ROE is growing, its P/B ratio should be doing the same.
· A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company.
For Value Investors
P/B remains a tried and tested method for finding low-priced stocks that the market has neglected. If a company is trading for less than its book value (or has a P/B less than one), it normally tells investors one of two things: either the market believes the asset value is overstated, or the company is earning a very poor (even negative) return on its assets. If the former is true, then investors are well advised to steer clear of the company's shares because there is a chance that asset value will face a downward correction by the market, leaving investors with negative returns. If the latter is true, there is a chance that new management or new business conditions will prompt a turnaround in prospects and give strong positive returns. Even if this doesn't happen, a company trading at less than book value can be broken up for its asset value, earning shareholders a profit.
What are Limitations?
·
The ratio is really only useful when you are looking at capital-intensive businesses or financial businesses with plenty of assets on the books. Book value doesn't carry much meaning for service-based firms with few tangible assets. Eq: Infosys whose bulk asset value is determined by intellectual property
· Book value doesn't really offer insight into companies that carry high debt levels or sustained losses. 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.
The Bottom Line
Admittedly, the P/B ratio has shortcomings that investors need to recognize. But it offers an easy-to-use tool for identifying clearly under or overvalued companies. For this reason, the relationship between share price and book value will always attract the attention of investors.
We will explain Debt Equity Ratio in the next edition on Mirae Asset Knowledge Academy Tutorials.
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