What Is The Price-To-Book Ratio?
The price-to-book, or PB, ratio is a valuation metric that compares a company’s market cap to the book value of its equity.
How To Calculate The Price-To-Book Ratio
A company’s PB ratio can be easily calculated with components from its balance sheet. Using the formula below, investors can calculate a company’s PB ratio.
PB Ratio = Price Per Share / Book Value Per Share
Where
Book Value Per Share = Total Equity – Preferred Equity / Shares Outstanding
What Does The PB Ratio Tell You?
As Stated Before, the PB ratio compares a company’s market value to its book value. So, investors generally use the PB ratio in a similar manner to other price ratios. In theory, a company trading at low price ratios is cheap. Book value specifically, is a strong measure of value because it represents the cash a firm could generate if it liquidated all of its assets and paid off its liabilities.
It is important to understand that companies seldom trade at or below book value because market valuations reflect future prospects. This is why faster growing companies tend to trade at large premiums to book value. So, if the PB ratio demonstrates the premium the market is willing to pay for a company, investors should then decide for themselves if this premium is worth it or not. Because of this concept, many companies which trade below book value often have flawed financials, limited growth prospects, or no competitive advantages.
It is also important to remember that there is no specific good or bad PB ratio. As with any valuation metrics, PB ratios must be considered on a case-to-case basis. One reason for this is growth discrepancies across industries. The PB ratio is best used when compared with other metrics. Such as growth rates, other price ratios, and the PB ratios of very similar companies.
Price-To-Book Value Limitations
At one time, the PB ratio was the pinnacle of business valuation. Today, however, its authority has been distorted. This is due to the dramatic increase in intangible assets. Because of the difficulty of place a precise valuation on intangible assets, companies’ balance sheets often under value companies. Another limitation to the PB ratio is the lack of accuracy in valuation of all assets on the balance sheet. Depending on accounting methods, assets on a company’s balance sheet may be carried at out-dated values. Also, because the PB ratio is calculated on a per share basis, it is easily manipulated via share buybacks. The PB ratio can mislead investors into believing a poor-preforming company is a value opportunity. In conclusion, it is important that your research does not depend specifically on the PB ratio, or any singular statistic.