The Importance of the P/B Ratio for Stocks
If you’re looking to invest in stocks, chances are you’ve heard of the price-to-book value ratio or P/B ratio.
This metric gives investors an idea of what the market as a whole thinks of your stock, and it’s crucial information to keep in mind when trying to figure out whether or not the stock is worth buying.
This article will enlighten you all about the price-to-book value ratio and how it can help you make good investment decisions.
In this article let’s learn about,
- What is a P/B Ratio?
- Steps in Calculating P/B Ratio
- Investing Tips on P/B Ratios
- Things to Know Before Investing
What is a P/B Ratio?
A price-to-book value ratio (P/B ratio) is a fundamental analysis metric that compares a company’s share price to its book value. The P/B ratio is an indicator of how much investors are willing to pay for a stock, compared with its net assets.
The P/B ratio only looks at common stockholder equity. Research has shown that stocks with low P/B ratios tend to outperform stocks with high P/B ratios over time.
The opposite is also true: companies with high P/Bs tend to underperform their peers with lower ones.
The higher that number is, theoretically, the more investors think a company’s future earnings are worth it. Some analysts suggest comparing it with similar companies.
If a company has a P/B ratio above average in its industry, that’s generally considered good and vice versa.
Steps in Calculating P/B Ratio
Fundamental analysis involves comparing a stock’s price to its fundamentals. Here are two ways in calculating the P/B ratio,
Way 1 – Market Capitalization Method
First, look at how much a company is currently worth by calculating its market capitalization.
Do not use your own estimate; try to find values on reliable websites. If it has no market cap, then just multiply all outstanding shares by the current stock price.
Market Capitalization = Share Trading Price*Total Outstanding shares
Then find the book value of equity by deducting the Total Liabilities from the Total Assets of the company.
Book Value of Equity = Net Assets – Net Liabilities
Now divide the Market capitalization by the book value of equity to get the Price to Book value.
Price-to-Book Ratio (P/B) = Market Capitalization / Book Value of Equity
Example for Way 1
Financials of “Company A”
- Total Assets- $5 Billion
- Total Liabilities – $3 Billion
- Total Outstanding Shares – 100 Million
- Share Last Trading Price – $50
Market Capitalization = $50*100 Million = $5 Billion
Book Value of Equity = $5 Billion-$3 Billion = $2 Billion
Price-to-Book Ratio (P/B) = $5 Billion/$2 Billion = 2.5
Way 2 – Share Price Approach
First, find the book value of equity by deducting the Total Liabilities from the Total Assets of the company.
Book Value of Equity = Net Assets – Net Liabilities
Then find the book value of equity per share by deducting the Book value of Equity by total Outstanding Shares.
Book Value of Equity per Share = Book Value of Equity/Total Outstanding shares
Now divide the Share Trading Price by the book value of equity per share to get the Price to Book value.
Price-to-Book Ratio (P/B) = Share Trading Price / Book Value of Equity per Share
Example for Way 2
Financials of “Company B”
- Total Assets – $5 Billion
- Total Liabilities – $3 Billion
- Total Outstanding Shares – 100 Million
- Share Last Trading Price – $50
Book Value of Equity = $5 Billion-$3 Billion =$2 Billion
Book Value of Equity per Share=$2 billion/ 100 Million = $20
Price-to-Book Ratio (P/B) = $50/$20 = 2.5
Investing Tips on P/B Ratios
P/B Ratios & Book Values P/B ratios are a popular valuation metric used in investing because they’re easy to calculate and understand.
When you’re looking at companies that trade on public exchanges, most information about them is readily available online. Because P/B ratios compare two values, they can be useful in comparing businesses with different capital structures.
According to Warren Buffet, P/B has been a good indicator of future returns, he has said he uses P/B above 1.2 as an indication to invest in stocks.
When stocks are trading below their book value (or some would say below intrinsic value), investors feel there is still plenty of room for growth before stocks become overvalued.
Conversely, when stocks are trading above their book value, investors feel that they have already priced in expected growth.
Things to Know more before investing
It’s also important to remember that most ratios can be used as only one piece of information in deciding whether or not to buy or sell shares.
There are other good fundamental analysing ratios like P/E ratio, Cash flow and Techincal Factors like ROI before selecting a stock to invest in the long term.
As with any investment decision, always do your own research before buying or selling stocks based on their price-to-book value ratios.