Fundamental Analysis: Understanding the Price-to-Book Ratio

Value Investing and Book Value

Value investors are as concerned about profit growth as they are about their perception of the intrinsic value of the company. They hope to find value before the rest of the market does.

One of the metrics that value investors use to test this value is the price-to-book ratio or P/B ratio. This metric looks at the value that the market places on a share at a given point in time compared to the book value of the company. The market value is represented by the share price.

The book value is equal to the amount of shareholders’ equity shown on the company’s balance sheet. You can also calculate the book value of a company as follows:

Assets – Liabilities = Book Value

Let’s assume that the company suddenly ceased operations. Any assets left after settling debts equal the company’s value. You can then divide this amount by the number of outstanding shares to arrive at the company’s book value.

Note: Healthy financial companies will always trade at more than their book value. Investors price the share based on their expectations for the company’s future growth.

Calculating the Ratio

You can calculate the price-to-book ratio using this formula:

Price-to-Book Ratio = Share Price / (Assets – Liabilities)

Interpreting the Result

You will find lower P/B ratios on stocks that may be undervalued. The higher the P/B ratio, the more likely the market is overvaluing the share. Consider the results in the context of other stocks in the same sector when using this ratio to analyze a particular stock. P/B ratios will vary by industry group.

Like all fundamental analyses, there are many other factors that leave this ratio open to interpretation. The price-to-book ratio can be distorted if the share price is affected in the short-term by market mechanics. This can make the ratio irrelevant.

The meaning of the result can also be distorted if the company appears to have a large amount of total assets but mainly consists of slow-moving inventory. You might use the averaged share price over the past 12 months when calculating the P/B ratio to filter out some noise.

Warren Buffett often offers his famous wisdom, “Price is what you pay. Value is what you get.” You become less concerned about price when using the P/B ratio as an investor, although it should have some impact. You become more focused on the long-term value that you believe lies within the company.

Only consider using the P/B ratio in your analysis if you have the patience to stay with a particular stock for a long time. You will find that using it to discover short-term gains will not be an effective way to use it.

Advantages and Disadvantages of Using the P/B Ratio

The P/B ratio helps investors assess companies by providing a relatively stable metric that is necessary. Investors can easily compare it to the company’s market share. The P/B ratio is still useful when a company has periods of negative earnings, unlike price-to-earnings ratios.

It is relatively rare to find a company with a negative book value compared to a company with negative earnings. However, it will make the ratio unhelpful in valuing the company if the company has many periods of negative earnings.

The P/B ratio becomes less useful when companies classify various balance sheet items due to applying different accounting standards. This complicates matters and reduces the meaning of comparing P/B ratios across companies. This is especially problematic in the case of the P/B ratio for a non-American company.

Companies with few assessable assets on the balance sheet, such as service providers or tech companies, also make comparing P/B ratios across companies meaningless if you evaluate them against a company that maintains a large amount of inventory or equipment.

For more

For information on fundamental analysis, please refer to earnings per share (EPS), dividend payout ratio, price-to-earnings (P/E) ratio, dividend yield, price-to-sales (P/S) ratio, and return on equity.

Source: https://www.thebalancemoney.com/fundamental-analysis-understanding-price-to-book-ratio-3140794

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