The price-to-book ratio is a financial valuation metric used to compare a company’s market value relative to its book value. It can also be referred to as market-to-book ratio or price-equity ratio.
The market value is the current stock price of all outstanding shares; in other words, the price that the market believes the company is worth. The book value is the amount that would be left if the company liquidated all its assets and repaid all its liabilities (debts). Book value is equal to the net assets of a company and derives from the balance sheet.
In other words, the price-to-book ratio is used to compare a company’s net assets that are available in relation to the sales price of its stock.
It allows investors to identify potential investment opportunities in companies and decide whether a company’s stock price is valued properly. The market value of equity is typically higher than the book value of a company.
Price-to-book ratios are used to value insurance, financial and real estate companies and investment trusts. They don’t work for companies with mostly intangible assets.
Price-to-book ratio formula
Price-to-book ratio = market price per share / book value per share
A price-to-book ratio of 1 means that the stock price is trading in line with the book value of the company. Price-to-book ratios below 1 are usually considered solid investments. A price-to-book less than 1 ratio could mean the stock is undervalued and worth buying.
A price-to-book ratio greater than 1 indicates that the stock price is trading at a premium to the company’s book value. It also indicates that you could be overpaying for what would be left if the company went immediately bankrupt.
However ratio analysis can vary by industry and a good price-to-book ratio for one industry might be a poor ratio for another.
Price-to-book ratio example
A mining company in Perth has AUS$50 million in assets on the balance sheet and AUS$15 million in liabilities. The book value of the company is calculated as total assets minus total liabilities. In this case AUS$50 million minus AUS$15 million = AUS$35 million.
If 2 million shares are outstanding, each share would represent AUS$2 of book value. If the share price is AUS$8, then the price-to-book ratio would be AUS$8 share price minus AUS$2 book-value-per-share = 4.
In other words, the stock is trading at 4x its book value. Whether the positive valuation in this instance is justified depends on how the price-to-book ratio compares to its value in previous years and the ratio of other companies within the same industry.
Criticisms of the price-to-book ratio
Investors find the price-to-book ratio useful because the book value of equity offers a fairly stable and intuitive metric that can be easily compared to market price.
However, because of its simplicity, the price-to-book ratio has weaknesses. Firstly, it is only really useful when applied to companies with a significant amount of assets on their books. This is good if you’re valuing a large manufacturing, financial or transportation business, but less so for service and information technology companies with less tangible assets on their balance sheets.
Book value also ignores intangible assets such as a company’s brand name, customer goodwill, patents and other intellectual company. For example, the hugely successful corporation Microsoft derives most of its asset value from intellectual property rather than physical property, so its share value has little relation to its book value.
High debt levels or sustained losses are also not taken into consideration in book value, while several scenarios such as recent mergers, write-offs or share buybacks could distort the book value figure in the equation.
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