Understanding price to book ratio

PRICE TO BOOK RATIO

Hi there,

before I begin my discussion on Price to book, a quick recap of some important terms. Book value’ is a concept we discussed at earlier stages.The Book Value is simply the company’s assets minus its liabilities. That is the actual worth of the company. But if you want to acquire that company, you need to buy every single share at the current market price and that value (ie market price per share x total shares) is called market capitalization.

i hope you remember those two terms – book value and market capitalization or market value.

PRICE TO BOOK RATIO

Price to book ratio is computed as follows -

Market capitalization / Book value OR

Market price per share / Book value per share.

Market price of the share and book values for any listed company are available straight from financial web sites. So there is no need to compute it.So let’s try to understand the ratio and it’s significance.

The P/B  gives you an idea of what the market is willing to pay for a share of company’s book value.The higher the P/B the more the market is willing to pay for the company’s book assets.  Some investors read a high P/B as an overpriced stock.

P/B ratios should be used with caution. A low price to book ratio can mean the following-

  1. That the stock is selling at a discount to its book value.  That gives you a perfect buying opportunity.
  2. Something is fundamentally wrong with the company.
  3. That the book value of assets is over stated in the company’s balance sheet

MORE ON P/B

  • Since market price is compared with book values, a distortion in the book value of assets of the company affects this ratio. For example, a company might have acquired land 10 years back. The value shown in the balance sheet would be the price paid at the time of acquisition, 10 years back. Naturally, the asset price would have shot up several Crores, but the same will not be reflected in the balance sheet. The price to book ratio of this company may look expensive, but in reality , it may be an undervalued stock.
  • Companies like software firms, which rely on intellectual property may have very high price to book ratios. They are not capital intensive and hence invest little in solid assets. Their assets are the intellectuals they have and hence P/B are not suitable for valuing such stocks.
  • Assets heavy companies like infrastructure, financial institutions, banks, manufacturing companies can be better valued with this ratio.
  • The ROE and P/B are inter connected. A company with a higher ROE will have a higher P/B and vice versa.

You may like these posts:

  1. Understanding price to sales ratio
  2. Price to Earnings ratio or P/E ratio
  3. Introduction to financial ratios

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