Understanding Price-to-Book Ratio
When you think of the greatest investors in the history of the stock market, names like Warren Buffett and Benjamin Graham come to mind. These legendary investors are proponents of "value" investing, and there is no fundamental analysis metric more associated with value than the price-to-book ratio. While you may never attain Buffett's wealth, you can become a member of this quiet group that invests in the long game.
Defining Price-to-Book Ratio
Simply put, the price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's current market price to the book value. It is also sometimes known as a market-to-book ratio. The idea behind "value investing" in the long-term is to find the market sleepers that other investors have passed by and hold on to them as the companies go about their business without gaining any attention from the market. Then, suddenly without warning or fanfare, the sleeper stock pops up on the screen of some analyst who “discovers” it and bids up the stock.
Meanwhile, as a value investor, you pocket a hefty profit, sometimes even becoming quite wealthy.
Two Ways to Calculate the P/B Ratio
If you choose to calculate the ratio the first way, the company's market capitalization is divided by the company's total book value from its balance sheet. But, if you choose to calculate the ratio the second way (i.e., using per-share values), you must divide the company's current share price by the book value per share. In other words, the value is divided by the number of outstanding shares.
Variations by Industry
As with most ratios, there's a fair amount of variation by industry. Industries that require more infrastructure capital (for each dollar of profit) will usually trade at P/B ratios much lower than, for instance, consulting firms. Price-to-book ratios are commonly used to compare banks because most assets and liabilities of banks are constantly valued at market values. A higher P/B ratio implies that investors expect management to create more value from a given set of assets. It's important to note that P/B ratios do not, however, directly provide any information on the ability of the company to generate profits or cash for shareholders.
Disadvantages of Using the P/B Ratio
When accounting standards applied by firms vary, P/B ratios may not be comparable, especially for companies from different countries. Additionally, P/B ratios can be less useful for services and information technology companies with few tangible assets on their balance sheets.
Companies in Distress
The P/B ratio also gives some idea of whether or not an investor is paying too much for what would be left if a company went bankrupt immediately. For companies in distress, the book value is usually calculated without the intangible assets that would have no resale value. In such cases, the P/B ratio should be calculated on a "diluted" basis, because stock options may vest upon the sale of the company or upon the firing of management.