When choosing your smartphone, you compare brands online on various websites, shopping sites for different features like processor, camera, screen. etc. You also checked for the processor, one of the important aspects of selecting the right phone as it measures the speed and overall performance of a phone.
Similarly, stock can be analyzed with the help of multiple ratios, indicators, fundamental and technical analysis. The P/B ratio is one such ratio that helps to analyze a stock’s performance.
P/B Ratio is an abbreviation used for Price-to-book Ratio. It represents the relationship between the market value and the book value of a company. This ratio is also known as the Market to Book Ratio. It is useful to decide on investment. If compared with other companies’ ratios, it gives more accurate insight.
Market value is reflected in the form of market capitalization to calculate this ratio.Market cap is calculated by multiplying the current share price with the total outstanding shares of the company.
Book value is the value of a company during liquidation. It is calculated by subtracting the total liabilities of the respective company from its total assets. This value is easily available on the balance sheet of a company.
For a note, intangible assets such as goodwill, patent, copyrights, etc. are not included on the balance sheet. Therefore, excluded from the assets for calculating book value.
Another way to calculate this ratio is by dividing the share price by book value per share.
This ratio is computed using below mentioned formula:
P/B Ratio = Market Capitalization / Net Book Value
Or
P/B Ratio = Price of share/ Net Book Value per share
The Net book value is the remaining amount when subtracting the total liabilities from total assets.
After the calculations, if the result is lesser than 1, it signals undervaluation. In contrast, if it is more than 1 it is an indication of overvaluation of the stock. Though, this is not a perfect interpretation.
An investor is sceptical about investing in company ABC’s stock which is trading at Rs.30/share. The number of shares floating in the market is 1,00,000. The total assets, including current and fixed, sum to Rs. 20,00,000. The total liabilities of the company, including long-term and short-term sums to Rs. 1,00,000. You need to calculate market capitalization and net book value to arrive at P/B Ratio.
Market capitalization = Current share price * Total outstanding shares.
= 30*1,00,000
=30,00,000
Net Book Value = Total Assets – Total Liabilities
= 20,00,000 – 10,00,000
= 10,00,000
Finally, P/B Ratio = Market Capitalization / Net Book Value
= 30,00,000/10,00,000
= 3 times
The stock of ABC is overvalued. Investing in ABC is a good decision, provided this is the only way to calculate stock value.
One of the limitations of using the P/B ratio to analyze a stock is that it does not consider intangible assets to calculate book value. Although, the exclusion of intangible assets would not be significant for multiple industries like manufacturing. It is because, generally, the proportion of tangible assets is higher in those firms. For the firms providing services based on intangible assets, ignorance of intangible assets in calculating book value will probably rank them undervalued.
Interpretation of the P/B ratio is another major limitation. If the stock is found undervalued after the calculation, it is generally believed to be a good investment. Though, it is not always true. The company may have some serious problems with its management or performance. There is a possibility of price manipulations by insiders, too.
However, if the stock is found overvalued it is believed to be a bad investment. Again, this may or may not be true. There are chances that the company is performing well compared to others in the industry or overall.
The P/B ratio only shows the result but not the reasons associated with it. Until the time investors do not know why the stock is undervalued or overvalued, they can become a victim of a bad investment.
Due to these loopholes, solely the price-to-book ratio is not considered 100% accurate for stock valuations. It should be used along with other investment methods.
The Price-to-Book Ratio is an important ratio to decide whether the price is fair or not. The ratio above one automatically assures that its market value is above its book value. In the opposite case, it is an indication that the stock is suffering from undervaluations.
As it does not inform the reasons behind the result, it is better to use this ratio along with other stock valuation methods to arrive at an investment decision.
The price-to-book ratio holds so much importance as it tells the investors whether they should invest in the respective stock or not. It will make the investors aware of whether they are paying a fair price for the stock. It indicates whether the company is undervalued or overvalued.
A P/B ratio of less than 1 is considered good as it signifies that the stock is undervalued and investing in such stock can give really good returns.
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