Names like Warren Buffett and Benjamin Graham might come to mind when you think of the greatest investors in the history of the stock market. These legendary investors are proponents of an investment plan known as value investing. No fundamental analysis metric has a stronger link to a company's value than the price-to-book ratio.
- One of the metrics that value investors use to test a company's value is the price-to-book or P/B ratio.
- The price-to-book value ratio looks at the value that the market places on the stock at a given point in time, as shown by its stock price, relative to the company's book value.
- You can figure out the price-to-book value ratio with the following formula: price-to-book ratio = stock price / (assets - liabilities).
- You'll find lower P/B ratios on stocks that could be undervalued. The more likely it is that the market has overvalued the stock if the P/B ratio is higher.
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. They hope to find the value before the rest of the market.
One of the metrics that value investors use to test this value is the price-to-book or P/B Ratio. This metric looks at the value the market places on the stock at a given point in time relative to the company's book value. Market value is shown by its stock price.
Book value equates to the amount of shareholders' equity shown on a company's balance sheet. You can also figure a company's book value like this:
Assets - Liabilities = Book Value
Suppose a company stopped doing business without warning. Whatever assets that remain after you liquidate to pay off its debt 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.
Financially sound companies will always trade for more than their book value. 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 this formula:
Price-to-book ratio = Stock price / (Assets - Liabilities)
Interpreting Your Result
You'll find lower P/B ratios on stocks that could be undervalued. The higher the P/B ratio, the more likely it is that the market has overvalued the stock. Think about the results within the context of other stocks in the same sector when you use this ratio to analyze a stock. Baseline price-to-book ratios will vary by industry group.
As with all fundamental analyses, many other factors leave this ratio open to interpretation. It can skew the price-to-book ratio if the price of a stock has been affected in the short term by market mechanics. This can make the ratio irrelevant.
It can also skew the meaning of your result if a company seems to have a large total assets number but it consists mainly of slow-moving inventory. 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." You become less concerned about price when you're using the P/B ratio as an investor, although it has to factor in somewhat. You become more focused on the long-term value that you think lies within a company.
Only think about 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 to discover a short-term upside won't be an effective way to use it.
Warren Buffett himself almost never sells his stocks, many of which he has held for decades. 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 gauge companies by providing a fairly stable metric that makes sense. Investors can easily compare it to a company's market price. The P/B ratio is still useful when a firm has a period with negative earnings, unlike price-to-earnings ratios.
It's somewhat less common to find a company with a negative book value versus one with negative earnings. But it will render the ratio useless in terms of estimating a company's value if a company has many periods of negative earnings,
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 harder 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 judging it by a company that holds a lot of inventory or equipment.