Introduction:
What is P/B ratio?
Formula for P/B ratio:
P/B ratio = Market price per share / Book value per share
Or
P/B ratio = Market capitalization / Book value of assets
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Market price per share = Current market price of the share.
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Book value per share = (Total assets – Intangible assets – Total liabilities) / Number of outstanding shares
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Market capitalization = Market price of the share x Number of outstanding shares
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Book value of assets = Total assets – Total liabilities
Market value per share can be derived simply by looking at the data available on most stock monitoring websites. To obtain total assets, total liabilities, and shares outstanding, you must find the company’s balance sheet.
Steps to calculate P/B ratio:
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Determine the book value.
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Now calculate the book value per share.
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Note down the current market price of the share.
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Now compute the P/B ratio.
Interpretation:
A good price-to-book ratio varies with the kind of industry and the growth prospects of the company. Analysts in most cases take a P/B ratio of below 1 as low, while a ratio greater than 3 or 4 is high. The investor should interpret the ratio relative to industry averages and historical trends.
A negative P/B ratio means that liabilities outweigh the value of its assets by a company. This, however, is not always bad news for investors. There are companies that have heavy debt, or economic factors outside the company temporarily affect it.
Thus, it is necessary for an investor to research the current financial status of the company and the prospect at hand so he or she can accurately assess what could have been the causes of the negative P/B ratio.
Higher P/B Ratio: It can indicate the expectation of high growth prospects from the company by the market or that the stock has crossed its book value.
Low P/B Ratio:
A very low P/B Ratio may indicate an undervalued stock, hence an attractive point to buy.Use of P/B ratio:
This ratio is a good indicator of a firm’s worth because it tells the market price of the company compared with its book value. This tool aids investors in determining whether a stock is undervalued or overvalued, thus guiding an informed investment decision.
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Assessing the value of the company: Most importantly, the price-to-book value ratio is useful in ascertaining a company’s intrinsic value. If the P/B Ratio is less than 1, the stock might be undervalued and can make a good investment. Conversely, an elevated P/B Ratio may indicate a stock to be overvalued.
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Comparing the companies within the industries: The P/B ratio can be useful in comparing companies within the same industry so that the investors know which one is trading at a premium and which one is trading at a discount relative to their peers. Generally, such a comparison will be important for investors when they look at long term investment stocks and want to identify opportunity.
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To identify the investment opportunities: Value investors use the P/B Ratio to find stocks that are selling below their book value-the stocks which maybe temporarily undervalued. This may result in future price appreciation because the market corrects itself.
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Financial health of the company: A low P/B ratio may depict problems within that company, while a high P/B ratio can indicate excellent financial activities. However, the usage of this ratio in conjunction with other factors should take place to help interpret the whole situation.
Limitation of P/B Ratio:
However, the only significant limitation in using this price to book value ratio is that tangible assets of the company are taken into account, while the intangible assets of the company are not; that is, the patents, intellectual property of the company, brand value, etc.
Thus, P/B ratio cannot be compared between two companies; a tech or pharma company will most likely have more intellectual property than a media company. The PB ratio fails also on account of the company’s future growth prospects.
Another limitation is the book value which is historically based, and so may not reflect the inflation and current worth of assets, hence the appreciation on the asset will also not be recorded such as the real estate held on books at historical price, which might worth much in the current market.
Conclusion:
P/B ratio, is a critical ratio in investment decisions. It compares the market price of a company to its book value to know if the stock is undervalued or overvalued. It is the ‘deal-breaker’ in identifying companies, when turned inside out and matched with peers, with prospects for investment.
But that doesn’t mean it has to be used in isolation and be interpreted in light of other financial metrics and industry trends. As with every investment decision, proper research and proper considerations on the basis of many factors have to take place before coming to a final verdict.
It is going to be through the application of the P/B ratio coupled with other financial metrics that investors will be able to build a comprehensive view of the true value of the company and make some of the smartest investment decisions ever.