To arrive at a decision to buy or sell a stock at an attractive value, investors have a number of valuation metrics at their disposal. Though price-to-earnings and price-to-sales are preferred by value investors while choosing value stocks, the price-to-book ratio (P/B ratio) is also a convenient valuation metric for identifying low-priced stocks, which have high-growth prospects.
The P/B ratio is used to calculate how much an investor needs to pay for each dollar of book value of a stock. It is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share.
P/B ratio = market capitalization/book value of equity.
Understanding Book Value
There are several ways by which book value can be defined. It is the total value that would be left over, according to the company’s balance sheet, if it goes bankrupt immediately. In other words, this is what shareholders would theoretically receive if a company liquidates all its assets after paying off all its liabilities.
It is calculated by subtracting total liabilities from the total assets of a company. In most cases, this would equate to common stockholders’ equity on the balance sheet. However, depending on the company’s balance sheet, intangible assets should also be subtracted from the total assets to determine the book value.
Explaining the P/B Ratio
By comparing the book value of equity to its market price, we get an idea of whether a company is under- or overpriced. However, like P/E or P/S ratio, it is always better to compare P/B ratios within industries.
A P/B ratio less than one means that the stock is trading at less than its book value, or the stock is undervalued and therefore a good buy. Conversely, a stock with a ratio greater than one can be interpreted as being overvalued or relatively expensive.
But there is a caveat. A P/B ratio less than one can also mean that the company is earning weak or even negative returns on its assets, or that the assets are overstated, in which case the stock should be shunned because it may be destroying shareholder value. Conversely, the stock’s share price may be significantly high – thereby pushing the P/B ratio to more than one – in the likely case that it has become a takeover target, a good enough reason to own the stock.
