Price-to-Book Ratio

Below is an explanation of the price to book ratio (P/B), how to calculate it, and what it's used for.

What is the price-to-book ratio (P/B)?

The price-to-book ratio (P/B), is a financial valuation metric used to evaluate a company’s current market value relative to its book value. The market value is the current stock price of all outstanding shares (i.e. the price that the market believes the company is worth). The book value is the amount that would be left if the company liquidated all of its assets and repaid all of its liabilities. The book value equals the net assets of the company and comes from the balance sheet. In other words, the ratio is used to compare a business’s net assets that are available in relation to the sales price of its stock.

The ratio is typically used by investors to show the market’s perception of a particular stock’s value. It is used to value insurance and financial companies, real estate companies, and investment trusts. It does not work well for companies with mostly intangible assets. This ratio is used to denote how much equity investors are paying for each dollar in net assets.

The price-to-book ratio is calculated by dividing the current closing price of the stock by the most current quarter’s book value per share. The formula is:

Market Capitalization / Total Book Value

or

Share Price /  Book Value per Share

A lower ratio (less than 1) could indicate that the stock is undervalued (i.e. a bad investment), and a higher ratio (greater than 1) could mean the stock is overvalued (i.e. a good investment). Many argue the opposite and due to the discrepancy of opinions, the use of other stock valuation methods either in addition to or instead of P/B could be beneficial for a company.

A lower ration could also indicate that there is something wrong with the company. This ration can also give the impression that you are paying too much for what would be left if the company went bankrupt.

The price-to-book ratio helps a company determine whether or not its asset value is comparable to the market price of its stock. It is best to compare P/B ratios between companies within the same industry.

How is the price-to-book formula derived?

The P/B multiple can be shown to be equal to PE x ROE by doing some financial analysis.  It is therefore driven by return on equity and the drivers of the PE multiple.

It can also be shown that the PE multiple is driven by (1 – g/ROE) / (r – g) where r is the cost of equity, g is the growth rate, and ROE is return on equity.

Since the PB multiple is PE x ROE, this means the PB multiple is ( ROE – g ) / (r – g).  If we assume a zero growth rate, the equation implies that the market value of equity should be equal to the book value of equity if ROE = r.

The PB multiple will be higher than 1 if a company delivers ROE higher than the cost of equity (r).