Financial Freedom 101

The price to book ratio is a common valuation ratio that allows investors to find out what they are paying in stock price relative to the net value of the company’s assets. It is a measure of how much a company would be worth today if it sold off all its assets and paid back all its liabilities.

P/B ratio is only good for tangible assets which are assets that you can physically touch like cash, real estate, and equipment. P/B ratio is not a good valuation metric for technology companies because the value of tech companies usually lies in intangible assets like software and trademarks that don’t have a physical monetary value attached to them

Calculation

It is calculated by one of the following two methods:

1. Price/Book Value = Total Market Capitalization / Total Book Value

2. Price/Book Value = Latest Closing Stock Price / Bok Value Per Share (as of the latest quarter)

Either calculation will yield the same result. Taking a per share approach to calculating the price to book may be easier as the price per share and book value per share is often readily available by most stock trading platforms, Price to book can also be referred to as market to book or market cap to equity ratio.

What is a good Price to Book Ratio?

Value investors like Warren Buffett often consider stocks with a P/B value under 3.0. as a good price to book ratio.

For example, if company A is priced at $500, but its book value is $250, then its P/B ratio would be 2.00. Thus, the stock price is double the book value. Ignoring growth or other factors, this stock could not be characterized as a value investment. It is overbought, meaning the share price is much higher than what it should be. This is reflected in the very high P/B ratio. Warren Buffet would likely not buy this stock.

If company B is priced at $30, and its book value is $30, then its P/B ratio would be 1.00. Thus, the stock price is equal to the book value. As long as the company has a good future outlook, and a sustainable business plan, for example, then this would qualify as a value investment. The P/B ratio indicates a fairly priced stock.

Significance of the price-to-book ratio

A P/B ratio of less than 1 indicates that a stock is undervalued and, everything else being equal, it may be poised for a rise. A 1 ratio, though, may indicate “fair” pricing, where the market value is equal to the company’s book value.

A P/B ratio of 3 or higher, however, could signal a market value that’s too high and may be ready for a fall.

That being said, it’s tricky to determine a single standard for “good” or “bad” P/B ratios. Every industry has a different range; what’s high in one field may be low in another.

That’s because some companies have more assets on the books than others like a service company. For example, my garbage company has more overhead costs than a tech company like Facebook ($FB) or Smith Micro Software ($SMSI)

Differences like that could lead to unrealistic company-to-company comparisons. So, while P/B ratio analysis may be useful in weighing valuations between companies, investors should be careful to compare “apples to apples,” because book value is not of much use for companies holding significant intangible assets on their Balance Sheets such as technology and service-oriented firms. Hence the ratio becomes more useful when valuing asset-driven companies such as financial institutions or real estate developers.

Also, one needs to be cautious enough to look through as accounts can be messed with to inflate book value, therefore conducting financial due diligence on the part of investors should also be mandatorily followed.