Investors are always looking for stocks that are undervalued, but how is that value determined? The price-to-book (P/B) value is a relatively crude way of determining the value of stocks, but it does serve a useful purpose when comparing investment opportunities.
The P/B ratio, also known as the price-to-equity ratio, is a measure of the price that investors are willing to pay for the amount of assets that the company holds. To calculate a P/B ratio, divide the share price at any point in time by the book value of the company.
Book value, also known as shareholder's equity, is the total value of the assets of the company minus the total liabilities. It is essentially what would be left over if the company liquidated all assets and repaid all the liabilities. You can calculate the P/B ratio from a company's balance sheet by dividing the shareholder's equity by the number of common shares outstanding.
P/B ratios are available through online outlets for both individual companies and funds. With respect to mutual funds or indices such as the S&P 500, the P/B value represents some sort of composite value of all the companies indexed (typically weighted averages for funds).
A P/B ratio of 1 indicates that the stock or fund is trading at its true value as defined by assets. A higher P/B ratio means a stock is trading above its asset-based value; lower P/B suggests its trading below value. There is no implication as to why or whether that price is warranted. Investors generally look for relatively low price-to-book ratios as a starting point, and then decide whether that's a sign of a value buy or a company in trouble.
Assets are very different in nature between industries, and as a result, the P/B ratio is best used to compare companies in the same field or sector. Trying to compare a software company with mostly intellectual property and intangible assets to a manufacturing facility with capital-intensive operations is fairly pointless. Intellectual property, brand names, and goodwill are notoriously difficult to quantify and are not often included in the asset calculation. For example, compare Facebook’s (NASDAQ: FB) P/B ratio to Twitter’s (NYSE: TWTR) P/B ratio. Both of these companies are in the same field and have fewer capital investments than the industrial company Caterpillar (NYSE: CAT) has.
Consider some other ways in which P/B ratios are of limited analytical value. Book value is historical in nature, not reflecting inflation or depreciation — therefore the P/B ratio compares a dynamic value (stock price) with a relatively static value (book value).
Book value also may not mean much for startups, who have significant amounts of debt in the early stages. When liabilities outweigh assets, the P/B ratio goes negative and has no reasonable meaning.
At that point, you have to consider the reason why the book value is negative.
Is this an established company with an overwhelming debt such as a court judgment, or a string of bad losses? If it is a startup, when should income be expected to lower the debt significantly? Your job as an investor is to find out whether the company is likely to grow or recover from the current negative book value or is likely to continue on a downward path.
A good use of the P/B ratio is to compare it with return on equity (ROE), which is the net income for the year compared to the shareholder's equity (book value). If ROE and the P/B ratio are rising in tandem, that means that the share price is driven by good returns on their assets — in other words, growth.
A high P/B ratio and low ROE may mean there is overenthusiasm about the stock, since investors are willing to pay more than the returns so far would warrant. That may be reasonable if, for example, there is an outstanding product introduction to come — but you have to assess whether this actually indicates overvaluation driven by hype.
In short, P/B ratio is a useful tool within context. It is good for a relative comparison of two or more similar company stocks and to point to potentially overvalued or undervalued stocks. P/B ratio is also a great indicator of places to dig deeper for information, but unfortunately not much more. It does not say anything about whether the stock will rise or fall after you buy it, which is what you really care about as an investor.