What is a Price-to-Book Ratio (P/B)?
The price-to-book ratio measures a company's market price in relation to its book value. The ratio denotes how much equity investors are paying for each dollar in net assets.
Book value, usually located on a company's balance sheet as 'stockholder equity,' represents the total amount that would be left over if the company liquidated all of its assets and repaid all of its liabilities.
How Does a Price-to-Book Ratio (P/B) Work?
There are a couple ways to calculate book value, depending on the company. For purposes of this example, we'll assume that the best measure of book value is Total Assets - Total Liabilities. We'll also assume that the stock of Company XYZ is trading at $6 per share and there are 100 shares outstanding.
Balance Sheet for Company XYZ
year ending December 31, 2009
Assets
Cash 1,000
Accounts Receivable 500
Inventory 500
Total Current Assets 2,000
Liabilities
Accounts Payable 500
Current Long-Term Debt 500
Total Current Liabilities 1,000
Long Term Debt 500
Total Liabilities 1,500
Owners' Equity 500
P/B ratio = Stock Price / Book Value per share
Book value: 2,000 - 1,500 = 500 (note that this is the same as owners' equity)
Book value per share: 500 / 100 = $5
P/B ratio = $6 / $5 = 1.2
A P/B ratio of less than 1.0 can indicate that a stock is undervalued, while a ratio of greater than 1.0 may indicate that a stock is overvalued.
Please note that it is not always reasonable to calculate book value as Total Assets - Total Liabilities. Depending on the company's balance sheet, it might make sense to subtract intangible assets, goodwill, and/or preferred stock from the appropriate sections of the balance sheet.
Why Does a Price-to-Book Ratio (P/B) Matter?
The price-to-book ratio indicates whether or not a company's asset value is comparable to the market price of its stock. For this reason, it can be useful for finding value stocks. It is especially useful when valuing companies that are composed of mostly liquid assets, such as finance, investment, insurance, and banking firms.
The price-to-book ratio is not as useful for firms with large R&D expenditures or firms with high levels of property or other fixed assets. Since long-term assets are held on the balance sheet at the original cost, if market prices of those assets increases or decreases dramatically, book value can differ dramatically from market value.
Like most ratios, it's best to compare P/B ratios within industries. Tech stocks, for example, often trade above book value while financial stocks often trade below book value.
