Fundamental Analysis: Understanding Price to Book Ratio
The Secret Weapon of Value Investors
When you think of the greatest investors in the history of the stock market, names like Warren Buffett and Benjamin Graham might come to mind. These legendary investors are proponents of an investment strategy known as value investing, and no fundamental analysis metric has a stronger association with a company's value than the Price to Book Ratio.
Value Investing and Book Value
Value investors don't concern themselves with earnings growth nearly as much as their perception of the intrinsic value of a company, which they hope to discover before the rest of the market.
One of the metrics value investors use to test this value is the Price to Book or P/B Ratio. This metric looks at the value the market currently places on the stock, as shown by its stock price, relative to the company's book value.
Book value equates to the amount of Shareholders' Equity shown on a company's balance sheet. You can also calculate a company's book value as follows:
Assets - Liabilities = Book Value
A better way to think of it might be, suppose that a company stopped doing business immediately. After you liquidated all of its assets to pay off all of its debt, whatever assets remain equate to the firm's value. You can then divide that amount by the number of shares outstanding to arrive at the company's book value.
Ongoing, financially-sound companies will always trade for more than their book value because investors price the stock based, in part, on their anticipation of the firm's future growth.
Calculating the Ratio
You can calculate the Price to Book Value Ratio with the following formula:
Price to book ratio = Stock price / (Assets - Liabilities)
Interpreting Your Result
You will find lower P/B ratios on stocks that could be undervalued. The higher the P/B ratio, the more likely the market has overvalued the stock. When you use this ratio to analyze a stock, consider the results within the context of other stocks in the same sector because baseline Price to Book Ratios will vary by industry group.
As with all fundamental analysis, many other factors leave this ratio open to interpretation. For example, if the price of a stock has been affected in the short term by market mechanics, it can skew the Price to Book Ratio to the point that it becomes irrelevant. If a company seems to have a large total assets number, but it consists mainly of slow-moving inventory, this can also skew the meaning of your result.
As a solution to this, you can use an average stock price based on the last 12 months when calculating the P/B ratio to filter out some of the noise.
Warren Buffett has often offered the wisdom of, "Price is what you pay. Value is what you get." When using the P/B ratio as an investor, you become less concerned about price, though it has to factor in somewhat, and more focused on the long-term value that you think lies within a company.
Because of this, only consider using the P/B ratio in your analysis if you have the patience to stay with a given stock for a long time. You'll find that using it to try and discover short-term upside won't be an effective way to use this tool.
Warren Buffett himself almost never sells his stocks, many of which he has held for decades, as he patiently waits for them to achieve the value he thinks they possess.
Pros and Cons of Using the P/B Ratio
The P/B ratio helps investors evaluate companies by providing a fairly stable metric that makes intuitive sense and which investors can easily compare to a company's market price. When a firm has a period with negative earnings, the P/B ratio is still useful, unlike price-to-earnings ratios.
It's somewhat less common to find a company with a negative book value versus one with negative earnings. If a company has several periods of negative earnings, however, this will render the ratio useless in terms of estimating a company's value.
The P/B ratio becomes less useful when firms classify balance sheet items differently due to the application of various accounting standards. This makes it much more difficult and less meaningful to compare P/B ratios across firms. This is especially problematic with a P/B ratio on a non-U.S. company.
Firms with few tangible balance sheet assets, such as service providers or tech firms also make a comparison of P/Bs across companies meaningless if you're comparing to a company that holds a lot of inventory or equipment, for example.
See the following topics for more on fundamental analysis:
Interested in using more than just fundamentals? Check out this series on technical analysis.