Fundamental Analysis: Understanding Price to Book Ratio
The Price to Book Ratio is 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 come to mind. These legendary investors are proponents of "value investing" and there is no fundamental analysis metric more associated with value than the Price to Book Ratio.
Value investors are not as concerned with earnings growth as much as what they perceive is the "intrinsic value" of a company -- something they hope to discover before the rest of the market.
One of the metrics they use to find this value is the Price to Book Ratio or P/B which looks at the value the market is currently placing on stock relative to its book value.
What is book value you might ask? Book value is calculated as so;
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 and paid off all of its debt, what would be left over? You can then divide that amount by the number of shares outstanding and you have the book value.
An ongoing and healthy company will always trade for more than its book value in anticipation of future growth.
So to calculate the Price to Book Value Ratio you just follow this formula;
Stock Price / (Assets - Liabilities) = P/B
The lower the P/B ratio the more likely that a stock is undervalued, and the higher, the more likely it is overvalued.
When using this ratio to analyze as stock it should be taken in context with other stocks in the same sector because baseline Price to Book Ratios will vary by industry group.
As with all fundamental analysis, there is a lot that is 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 is irrelevant.
A solution to this is to use an average stock price based on the last 12 months when calculating the P/B ratio in order to filter out the noise.
Warren Buffett is quoted as saying, "Price is what you pay. Value is what you get." When using the P/B ratio as an investor you are not as concerned about price -- though it has to factor in somewhat -- as you are the long-term value that you think can be unlocked in a company.
Because of this, you should only use the P/B ratio in your analysis if you have the patience to stay with a stock for a long time. Using it to try and discover short-term upside is not an effective way to use this tool.
Warren Buffett himself almost never sells his stocks, many of which he has held for decades, in order for them to achieve the value he thinks they possess.
See the following topics for more on fundamental analysis;
- Earnings per Share - EPS
- Price to Earnings Ratio - P/E
- Price to Sales - P/S
- Dividend Payout Ratio
- Dividend Yield
- Return on Equity
As my series on fundamental analysis continues we will cover all those topics so you can get a well-rounded understanding of the process of picking winning stocks.
Even if you use fundamentals, why not check out my series on technical analysis as well?
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