Understanding Price to Book Ratio for Investing
Price-to-earnings is a popular measure, but an imperfect one. P/E Ratio will explain to people what they willing to pay for of earnings, and another one that’s closely watched by people who are looking for bargains and investment bankers alike, is book value.
Book value is the corporate equivalent of a person’s net worth. Investment bankers often focus on tangible book value, because it strips out assets that may be hard to accurately value or quickly sell. Book value is calculated as the difference between a company’s total assets and total liabilities.
Book value of a company = Total assets – Total liabilities
The price-to-book ratio is the company’s stock price divided by book value. The ratio tells how much investors are paying for every penny the company would raise if it were. The P/B ratio examines the market cap in relation to the book value of a company as shown on its balance sheet. The ratio is calculated as follows:
P/B Ratio = Stock Price / Book Value of a company
In some conditions, the P/B Ratio is preferable to P/E like:
- Dealing with a young company: When companies are just starting out, they may have diminutive levels of earnings or even losses
- When a cyclical company is in a downturn: Earnings of some companies rise and fall by large degrees along with the ups and downs of the economy. During periods of economic decline, a company’s P/E may look artificially high if the stock price hasn’t fallen by as much as earnings
- Dealing with a capital-intensive business: In some industries, massive investments in plant, property, and equipment are required. These firms may make enormous investments that are more significant to the value of the company.
The lower the P/B ratio of a stock, the stock is categorized as undervalued, which is very good for deciding long-term investments. The low value of the P/B ratio must be caused by a decrease in stock prices, so that the stock price is below the book value or the actual value. Therefore, we must compare the P/B ratio with the P/B ratio of the same company sector. If the difference is too far with the others, then it should be analyse deeply.
But for some types of companies, the P/B ratio is less effective because of the fundamental difficulties for traditional accounting for high-tech-based companies. The main assets of this type of company are “intellectual property” which is a “great value” that is difficult to record in ordinary financial accounting. So that this type of company book value does not reflect the true wealth of this technology company.
Reference :
- https://www.investopedia.com/articles/investing/110613/market-value-versus-book-value.asp
- https://www.investopedia.com/investing/using-price-to-book-ratio-evaluate-companies/
- https://www.dummies.com/personal-finance/investing/investment-banking
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