When you’re evaluating whether to purchase a stock, you need to asses a stock’s value. One way to assess the value is to compare the price you pay for a share of stock to the company’s value as defined by the balance sheet. In other words, you can compare the market cap for a stock to the company’s book value. This ratio is called the Price to Book ratio (or P/B Ratio for short). Here’s what you need to know about it.
What is the P/B Ratio?
To understand the P/B ratio, you need to understand it’s components. This starts with understanding Market Capitalization or Market Cap. Market Cap is the price per share of stock multiplied by the number of outstanding shares. In other words, its the amount you would pay for the whole company if you bought all the shares today.
Its important to distinguish current Market Cap from the trailing 12 month market cap. The trailing twelve month market cap explains how much you would pay for the company if you paid the average share price (for the last 12 months) for the average number of outstanding shares (for the last 12 months).
For the sake of calculating the P/B ratio, we use the true Market Cap instead of the trailing twelve month market cap.
Next, you need to understand the book value of a company. The book value is the value of all the tangible assets on a company balance sheet less any debts or liabilities that the company owes. The book value doesn’t include assets like “Brand equity” or patents that have financial value.
The price to book ratio (P/B Ratio) is the ratio of market cap to book value.
|P/B Ratio =||Market Cap (or Price per Share)|
|Book Value (or Book Value Per Share)|
How should I use P/B Ratio?
If a company has P/B ratio less than one, the stock may represent an opportunity. A P/B ratio less than one indicates that the market believes that the book value is overstated (steer clear of these stocks), or that the company is earning low returns on their assets. In second situation, a company could turn around and see huge growth.
If you believe that a company has growth potential, a low P/B ratio might indicate a good buy for you. This is a more useful metric in capital intensive industries (such as financial or commodity sectors) than it is in sectors where brand equity and patents pay a large role (such as technology).
As with most value based indicators, investors should compare the P/B ratio to other competitors and the sector average instead of comparing to a broad based index. This will show if a P/B ratio is truly low, or if the company is part of an industry with a low average ratio.
What traps should I avoid?
The first trap to avoid is to understand an important wrinkle in Book Value. If a large company buys another company, the acquired company is valued on the books at the purchase price. This means that Facebook’s purchase of Instagram is on the books as $1 Billion dollars. This would be true even if the acquisition was a flop. Serial “acquirers” have artificially high book values and therefore low P/B ratios.
The next trap to avoid is using P/B ratio by itself. You want to look for companies with real growth potential that show a solid record of earnings. Try to understand the direction of the industry and the company before you buy.