P/B Ratio: Meaning, Formula, and Relevance
The decision to purchase a specific stock is influenced by a variety of factors. Of course, the first factor is how well the underlying business is doing. But equally crucial is determining whether the company’s price-to-book ratio (P/B ratio) is reasonable – determining whether the stock price makes sense when compared to the net assets it owns.
In this article, we talk more about the ratio, how to calculate it, and what the value says about a business.
What is P/B Ratio?
The price-to-book value ratio (P/B) measures the market valuation of a company compared to its book value or the total value of the assets it owns. It helps the investors determine a fair price for the stock. This is why it is such a significant and well-known ratio among high-end investors. By comparing this to the stock's market value, one can quickly determine if the stock is overvalued, undervalued, or at its best price, and one can then decide whether to buy/sell/hold.
An investor frequently uses the P/B ratio, also known as the price-equity ratio, to determine the relationship between a company's market capitalization and the value of its assets. For brokers, in particular, this serves as a crucial agency to generate significant profits from the stock's intrinsic worth. Additionally, it helps in analyzing an industry's market trend.
Formula and Explanation for P/B
The formula for calculating the P/B ratio is:
P/B Ratio = Market Price per Share ÷ Book Value per Share
Alternatively, the P/B ratio can also be calculated by dividing the market capitalization of a company by the share’s book value:
P/B Ratio = Market Capitalization ÷ Book Value of Equity
Investors may interpret a lower P/B ratio, especially a ratio below one, as a hint that a company may be undervalued. In other words, the stock price is currently trading below the assets of the company's value. A low P/B ratio may also indicate that the company has a very low (or even negative) rate of return on assets (ROA). On the other hand, if the company has bad profit performance, there is a risk that new management or new business conditions will drive a reversal in prospects and provide high positive returns.
A higher P/B ratio indicates that the stock price is trading above the company's book value. For instance, a P/B value of three indicates that a company's stock is being traded at three times its book value. The stock price may therefore be excessively priced. A high ROA for the business may also be indicated by a high share price-to-asset value ratio. However, the high stock price can also mean that the majority of the positive company news has already been included in the stock. As a result, any further positive news might not increase the stock price.
How is the Value of the P/B Ratio Calculated?
To calculate the P/B book, there are two essential elements:
Market Share: You may determine a company's market price per share by searching up the value of its publicly listed stock. The investor may opt to use the market price for a predetermined period to calculate an average price.
Book Value: The book value of the business can be determined in a variety of ways. The best and most popular method for determining a company's book value is to subtract all liabilities from assets. For example, if, according to a company's balance sheet, it has Rs 10 lakhs in assets and Rs 5 lakhs in liabilities, then the book value for the company would be Rs 5 lakhs. If there are one lakh outstanding shares, then the book value per share would be Rs 5.
Once you have both of these elements, the P/B ratio can be easily calculated by diving both values.
Let’s assume the stock price, i.e. Rs 6, and the book value per share is Rs 5, and input these values into the formula for the P/B ratio. After entering the numbers into the formula, divide them to get the ratio.
P/B ratio = Rs (6/5) = 1.2
The P/B ratio for this company is 1.2, which indicates that the market value is equivalent to 1.2 times the book value.
What does the P/B Ratio tell you?
A P/B ratio under 1x is typically seen as a possible sign that the company's shares are currently undervalued. However, this is a generalized statement since the standard for the P/B differs by industry.
While lower P/B ratios generally indicate that a firm is undervalued, larger P/B ratios indicate that the company is overvalued – a closer analysis is still needed before any financial decision can be made. Another way to look at it is that poor performance can result in lower P/B ratios because the market value (the numerator) will logically decline.
It is important to remember that a low P/B ratio does not necessarily mean that a company is undervalued, or that it is an opportunistic investment. A low P/B ratio may point to issues with the business that could cause the value to decline in the years to come. Companies with P/B ratios significantly higher than 1.0x, however, may reflect recent strong performance and a more upbeat assessment of the company's prospects by investors.
The price-to-book ratio is more suited for established businesses, and it is particularly accurate for those with a significant amount of assets (for example, companies in the manufacturing industry). On the other hand, the P/B ratio is often avoided for companies that are mostly constituted of intangible assets (for example, software companies). This is because the majority of its value depends on its intangible assets, which are not always documented on a company's books.
The P/B ratio is a simple indicator that assesses a stock's market price and can be used to assess how it compares to other stocks in a related industry. The P/B ratio might indicate whether the price per share is appropriate, below what it should be, or outrageously overvalued.
Q. What is the P/B ratio formula?
The P/B ratio can be calculated by dividing the market capitalization by the book value of assets. Alternatively, investors can derive this ratio by dividing the current share price by the book value per share.
Q. What does a high P/B ratio indicate?
A high P/B ratio may indicate that the stock is overvalued. For instance, if a company's P/B ratio is 5, it means that the investors are paying five times for a business’s assets.
Q. What is a P/B ratio example?
Let’s assume that there are one lakh outstanding shares of the company, with a book value of Rs. 15 per share and a market price of Rs. 25, then the P/B ratio is 1.67.
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