What Is Price-to-Book Ratio?

You want to diversify your portfolio with some additional stocks. You begin looking through the list of each company’s key Financial Metrics to see which stocks might be good options. As you’re perusing the long list of valuation metrics, you see the price-to-book-value ratio. With so many metrics to analyze, it can be daunting to understand which ones to focus on and why. You’ve heard that a common valuation method is to evaluate a company’s price-to-earnings (P/E) ratio, but what about its price-to-book (P/B) ratio?

Although price-to-book ratio may not be the first metric you look at, it shouldn’t be the last. Multiple studies have found price-to-book-value (P/B) ratio to be a very effective valuation measure in determining a stock’s performance. Although the price-earnings (P/E) ratio is considerably more popular, buying at low price-to-book multiples may lead to better returns.

It’s important to know that calculating the P/B ratio is just one of the many ways you can value a company’s stock. We delve into what this specific ratio indicates, how to calculate price-to-book ratio, what a good price-to-book ratio looks like, as well as overall limitations of the P/B ratio.

What Is Price-to-Book Ratio?

Apart from the P/E ratio, a company’s price-to-book-value ratio is one of the most important Financial Metrics to evaluate before purchasing a stock or other security. To keep it simple, price-to-book ratio, also commonly referred to as P/B ratio, is a key financial metric that compares a company’s current market value to its book value.

This metric essentially shows potential investors and analysts the value given by the market for each dollar of the company’s net worth. A price-to-book ratio of 1.0 suggests the current price is equal to the proportionate amount of equity in the company that a shareholder can lay claim to by owning a share of the stock. It reveals whether or not the market is assigning a premium to a company’s net assets as consideration for the company operating as a going concern (a price-to-book ratio above 1.0) or if the market is suggesting to shareholders that they should liquidate the company (a price-to-book ratio less than 1.0).The P/B ratio is meant to help highlight and filter out companies that are undervalued and those that are overvalued so you can purchase at the right time.

How to Calculate Price-to-Book Ratio

The official price-to-book formula is to divide a company’s market price per share by its book value per share.

Company’s market price per share ÷ Company’s book value per share = P/B Ratio

To delve a bit deeper, the market value per share is obtained by simply looking at the share price quote in the market. Additionally, a firm’s book value per share is a measure of the value of its overall net assets (total assets less total liabilities). Potential investors can calculate a company’s book value per share by dividing the company’s book value by the number of its outstanding shares in the market.

As an example, we can take a look at Dell stock to see how a P/B ratio can be easily calculated and analyzed. As of December 29, 2021, AAII.com reported that Dell Technologies Inc. (DELL) had a P/B ratio of 4.95. Their market price per share at the time was $57.23 and their book value per share was 11.55.

Therefore, you would divide 57.23 by 11.55 to get Dell stock’s P/B ratio of 4.95.

Here is another, more general, example of how the book value and market price make up the P/B ratio and how it fluctuates:

If the market value and book value start off as equal (P/B of 1.0) and the market price suddenly drops, the P/B ratio would be less than 1.0, indicating that the company’s market valuation is less than its book valuation. This tells potential investors that the market sentiment is currently undervaluing the stock. For some investors, this would be an excellent time to buy an undervalued stock, especially if it also has a favorable P/E ratio or PEG ratio, with is the ratio of the price-earnings ratio to earnings growth.

However, let’s say that the next day the market price changed and is now greater than the book value. That tells us the market valuation now exceeds book valuation according to its balance sheet, which indicates that market sentiment is overvaluing the stock. This may be a good time to wait, avoiding the stock until market sentiment adjusts.

Understanding how each part of the P/B ratio is calculated can help investors see how the P/B ratio can help them analyze a company and determine its overall valuation.

How to Analyze Companies by Their P/B Ratio

Price-to-book ratio should be used to determine one simple thing: Is the market adequately recognizing a company’s worth as an ongoing concern? A well-managed company trading at or near book value is too cheaply valued and therefore should be considered as a potential investment.

What matters is whether the purchase price represents a reasonable discount. If management is capable of creating shareholder value in the future and the current price does not reflect this fact, then the stock is a good value. If management is suspect and the current price reflects too much optimism about the company’s prospects, then the stock is overvalued.

And the best way to determine whether the stock is undervalued relative to its prospects is book value. Great companies are always worth considerably more than the underlying value of their assets. Similarly, poorly managed companies and those with bad business models deserve to trade at valuations equivalent to the value of their assets because their future is uncertain.

What Is a Good Price-to-Book Ratio?

If you’re trying to decide what a good price-to-book ratio is, you can think of this rule of thumb: Look for a price-to-book ratio of 2.0 or lower, though 1.25 or lower is even better. A well-managed company trading at a significant premium to book value (price-to-book ratio of greater than 4.0) should be watched but is only suitable for speculative trading until the valuation becomes reasonable. A company that is not well managed should never be purchased for any reason.

If a company has superb management, a great business model and fiscal strength, but trades at a book value of 2.25, it could be considered for purchase. Is it a better value at a good price-to-book ratio of 1.25? Absolutely, but if the company is that well managed, then it should be trading at a premium valuation anyway. It is always better to pay slightly more for a great company than slightly less for a subpar company. It is never a good idea to pay a high premium for a stock, but do not pass on a great quality company just because its valuation is slightly above what you would like to pay.

As an individual investor, a lot of learning comes with trial and error. AAII recommends doing your research and looking at numerous Financial Metrics before determining if the stock is right for you.

Limitations of Using P/B Ratio

Even though the price-to-book ratio may be a good indicator to know when to buy a stock and determine if it’s overvalued or undervalued, there are a few limitations. In contrast to looking at the P/E ratio, the price-to-book formula can be used to evaluate a company that has a positive book value but negative earnings; while the P/E ratio cannot effectively be used to value this type of company. However, the P/E ratio may give a better overall idea of the valuation of the company, due to the P/B ratio’s limitations, such as:

• It’s not as comparable for international versus domestic companies;
• It’s less useful for service and information technology companies with few assets;
• A company’s assets must exceed its liabilities to be viable for this calculation;
• There’s little correlation between P/B ratio and overall profitability; and
• Companies that don’t include all assets and liabilities on the balance sheet means that crucial numbers are not reflected in the book value or price-to-book ratio.

Additionally, recent acquisitions, recent write-offs or share buybacks can distort the book value figure in the equation, making the P/B ratio not reflective of the overall value of the company and potentially misleading to investors. This underlines the importance of looking at multiple financial ratios rather than just the price-to-book ratio to determine the value of a company or other marketable security.

How to Find Price-to-Book Ratio on the AAII Website

To find a company’s P/B ratio, you can search for any stock on the AAII website. Once you find the stock you want to research, scroll down on its ticker page to the Financial Summary. There will be a section labeled Valuation where you can view the company’s price-to-book ratio as well as other key financial multiples like the P/E and PEG ratios as well as the dividend yield. In the same section, you can easily compare the company’s P/B ratio to its industry median and see it’s percentile ranking among all stocks. This can help you gain a better understanding of whether the stock has a good price-to-book ratio or not.

The stock ticker pages of AAII.com are a great place to start researching companies you want to invest in before putting your hard-earned money into the market.

Using the Price-to-Book Ratio to Invest

A company’s price-to-book ratio is a useful tool for examining the market valuation of a company relative to its overall book value. As with most fundamental analysis, it is important to understand the elements that go into calculating the ratio.

To use price-to-book ratios in a meaningful way, they must be compared to those of companies in similar industries. The low maximum limits for price-to-book ratio as a criterion reflect its appeal to value-oriented investors. The low limits also reflect the historical success of buying stocks trading near or below their net asset value and the underperformance of highly valued stocks. Additionally, if you are a value investor, it’s important to look beyond merely cheap stocks. Many investors pair a low price-to-book ratio with other indicators to better ensure the stock is a bargain, as opposed to merely cheap.

No matter what type of investor you are or what strategies you follow, understanding how to screen for stocks with a good price-to-book ratio as well as other key Financial Metrics is important when researching a company you may want to invest in.

With A+ Investor, you can conveniently add stocks and other securities to your My Portfolio as an AAII member so that you can analyze various metrics such as the price-to-book ratio.

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