Methodology

Stocks

Module 1

What does the price to book ratio tell you?

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Price-to-Books Ratio

Price-to-Books Ratio

Similar to price-to-earnings ratios, price-to-book ratios give you an idea of how much you are paying for a stock, compared with the underlying performance of the company. Instead of the earnings of the company, price-to-book ratios compare the stock price of a company with the book value of the company.

 

The book value of a company is its value when the liabilities of the company are subtracted from the assets. This tells you how much a company is worth, in terms of the assets it has. The stock price of a company is totally different from the book value of a company. The stock price is the price that investors are willing to pay for ownership in that company, while book value is the value of the company’s assets if all debts are paid.

 

So, in a way, the p/e book ratio is a ratio that compares the market value of a company (through the stock price), with the real value of the assets of the company.

Calculating P/B ratios

P/B ratios are calculated using the following formula.

Although it looks like one equation, you need to calculate the P/B ratio in 2 steps.

 

First, in order to calculate the book value per share, you need to subtract the liabilities of the company from the assets. This information will be available from the annual report of the company or on free sites like Yahoo finance. Then you need to divide this number by the number of shares outstanding. The outcome of this will be the book value per share figure.

 

Second, you need to divide the share price of the company by this book value per share number. This will then give you the P/B ratio of the company. For example, if a company has assets of $1bn and liabilities of $200m, then the book value of the company would be $800m. If the company has 500,000 shares outstanding, then the book value per share would be $1,600.

 

If the share price of the company is $2400 per share, then the P/B ratio would be 1.5. This means that the market price per share is 1.5x higher than the book value per share.

What is a good P/B ratio?

From the perspective of investors, an investment is desirable if it has a p/b ratio that ranges from below 1 to around 3. A stock that has a p/b ratio of under 1 is considered to especially be good, as the market value of the company is less than the value of the assets of the business. This means that the company is undervalued, with the investor paying less for stock in a company than the value of its assets.

 

This is attractive to many investors as it suggests that they will make a profit on an investment, even if the company goes out of business. This is the case because the assets of the business will be sold for more than the money that the investor spend buying the shares of the company.

 

Although a good p/b ratio is anything from below 1 to 3, it varies from one industry to another. So, as with the p/e ratio, investors should compare the p/b ratio of one stock with other stocks in the same field.

 

That way, the investors can observe whether a stock has an abnormal p/b ratio or not. If it is higher, then this may be a sign that the stock is over-valued, while if it is lower, then it may be a sign that the stock is under-valued.

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