When analyzing and researching stocks one of the most common ratios investors look at is the price-to-book ratio. But what does the price-to-book ratio tells investors about a company? Should you buy a stock with a high or low price-to-book? What is a good price-to-book for a company?
In this guide, we will answer all of these questions and look at all of the aspects investors need to consider when evaluating the price-to-book of a stock.
What is the price-to-book ratio?
The price-to-book ratio (P/B ratio) is a common financial metric used by investors to compare the company’s current market valuation with the equity value of the company. Since the equity shows investors the difference between the total assets of the company and the total liabilities, which can also be referred to as book value.
Comparing the book value and the valuation of the stock allows investors to understand how much they are paying for the stock (market capitalization) relative to the company’s assets minus liabilities.
Price-to-book ratio formula
There are two ways of calculating the price-to-book of a stock.
P/B ratio = Market capitalization / Book Value
The price-to-book ratio can also be calculated on a per share basis:
P/B ration = Stock price / Book value per share
Interpreting the P/B ratio
If the P/B ratio is 1, it means that the book value equals the company’s market capitalization. That means that for each $1 invested in the stock, the company also has $1 in assets minus liabilities.
A price-to-book under 1 means that the value of the company’s assets minus liabilities is higher than the current stock price. So for example, a P/B ratio of 0.5 means that for each $0.5 invested you will get $1 in book value.
A price-to-book over 1 means that the book value is worth less than the current stock price. For example, if you buy a stock with a P/B ratio of 2, each $1 invested guarantees just $0.5 in book value.
What the price-to-book ratio tells investors
The P/B ratio is a way of calculating the price of the stock and comparing it with the liquidation value of the business. If a business shuts down and the company gets liquidated, in theory, investors will receive the amount of equity value of the business. This is one of the reasons value investors use the price-to-book extensively in their stock research, but more on that later.
For this reason, the price-to-book value is usually a measure of the company’s valuation. Typically, stocks that have a higher price-to-book tend to have higher valuations, and companies with a lower P/B ratio are usually overvalued.
The P/B ratio can also be used to understand other aspects of the stock, such as:
Overstated assets or understated liabilities
While the P/B ratio is mainly used as a valuation metric, it can tell investors a lot more about the company and its accounting. If the market is particularly skeptical of the value of the assets and liabilities of the company that will be reflected in its price-to-book. As it will be discounted based on the possibility that the assets are worth less or the liabilities are worth more than what is currently stated on the balance sheet.
This is a risk for investors because when you invest in a stock you want to make sure the shareholder's equity is fairly accurate. Otherwise, your shares will not be worth as much. This shows the importance of interpreting the P/B ratio while also analyzing the company’s financials.
A common example of this situation is companies with high goodwill value. In some cases, the goodwill is overstated, which leads to a goodwill impairment that reduces the value of the company’s assets.
Impairments are also common in different assets of the company, from its inventory to current investments it has that may lose value over time.
Future earnings
Companies that are more likely to grow their earnings in the future will have higher valuations, and therefore their price-to-book also tends to be higher. As inventors bid up these stocks, it is common that growth stocks usually have a higher price-to-book.
A low price to book may also indicate a company with shrinking revenues and profits, and it is also associated with mature companies with lower expected growth.
Market sentiment towards the stock
The book value of the company relative to its market cap can also help investors assess the market sentiment towards the stock. If the market is extremely positive about the outlook of a company, it will have a higher P/B ratio. Conversely, if the stock is highly shorted, and the company is close to bankruptcy, its price-to-book will be lower to reflect the risks.
Industry and its outlook
Finally, price-to-book ratios tend to vary a lot depending on the industry of the company. Stocks in industries that are highly demanded by investors tend to have higher price-to-book ratios, reflecting the positive outlook.
It is also important for investors to understand how the price-to-book varies across industries. While some industries have historically had lower P/B ratios, others tend to be higher. This in part also reflects the margins of the company, as well as its return on equity, but we will analyze that in more detail later on.
What the price-to-book tells value investors
Historically, the P/B ratio has been used as a metric that can signal when a stock is undervalued. Traditionally, value investors have looked for stocks with a price-to-book under 1. This means that if the company gets liquidated investors will receive a higher amount per share than the stock price.
Obviously, there could be discrepancies between the accounted value of the business’ equity and the amount investors would receive when all the assets are sold. Ben Graham, the father of value investing was one of the first proponents of buying stocks under book value, or what is also referred to as a net-net stock.
The idea behind this strategy is that the difference between the book value of the stock, and its current price gives investors a margin of safety on their investment. Protecting them from possible losses, while also increasing the potential returns.
How to analyze the price-to-book ratio
The P/B ratio can be useful, but investors need to be able to analyze it from different angles. Here are some of the ways you can use to analyze the price-to-book ratio of a stock:
Industry P/B ratio
First of all, to analyze a price-to-book ratio we need to put it into perspective and compare it with the industry. Comparing the average P/B ratio of the industry with the stock will allow you to understand whether it is in the high or low range.
It will also help you determine whether a stock is overvalued or undervalued, relative to its industry. Moreover, the outlook of the company will also be somewhat reflected in its price-to-book.
A low industry P/B ratio can also signal that an industry is in decline and shrinking. Since the profits are expected to decrease, the value of the equity is also expected to be lower in the future. Therefore, investors are not willing to pay as much for the company’s equity, and that is reflected in the stock price.
Historical P/B ratio
While sometimes it may seem like a certain stock has a very low P/B ratio and may be undervalued, that does not mean that it is. One of the best ways to understand this is to analyze the stock’s P/B ratio historically, while also comparing it with the current S&P 500 P/B ratio.
This allows you to compare the stock’s price-to-book through the years, and understand whether or not the price-to-book is historically low or high.
There are several stock research platforms like Stock Rover that allow you to compare the P/B ratio historically, and you can sign up for free here.
Return on equity
The price-to-book value is closely related to a company’s return on equity. Since the price-to-book tells investors how much they are paying for the company’s equity, the return on equity will directly influence the price-to-book.
The return on equity measures how profitable the company is, and compares it with the equity value. It is calculated by dividing the yearly net income by the equity.
A company with a high return on equity will often have a higher book value. For example, if the return on equity of a stock is 20% and its P/B is 1, that means that an investor can expect a ~20% return yearly if he buys the stock today. For that reason, companies that have a higher return on equity have higher P/B ratios.
While analyzing the return on equity it is also important to put it into perspective, by comparing it historically and with the industry average return on equity.
Margins and price-to-sales
A company’s margins and price-to-sales will also affect how investors analyze the P/B ratio. While basing your investment decisions on these metrics individually can be a mistake, when analyze collectively, it can give you a very good idea of whether a stock is overvalued or undervalued.
It can also give investors a hint as to what returns they can expect from the business, and that should be reflected in the stock price over the long term.
For example, a company with a price-to-sales of 1 and an average net margin of 10%, and a P/B of 1, means company is expected to return around 10% a year.
What is a good price-to-book for a stock?
There is no single good price-to-book for a stock, because it is very dependent on different factors, and it should always be compared with the industry average and the current S&P 500 median P/B.
As a rule of thumb, most value investors will often consider a stock to be attractive when it has a price-to-book under 2.
A price-to-book under 1 typically signals that we are dealing with a very undervalued stock, and its equity is worth more than the current market capitalization. This is usually very attractive because it signals that the company is very undervalued. However, it can also signal that there are underlying issues with the business, and reflects the investment risk.
Well-established companies and growth stocks tend to have a P/B of over 3, reflecting the quality of the business and the positive outlook.
What does a low price-to-book ratio mean?
If the P/B ratio is less than 1 it usually means one or a combination of these things:
- The company’s valuation is low
- The future prospects of the company are grim
- Future earnings will be lower
- The industry is in decline
- The market is negative towards the company
- Skepticism towards the accuracy of the balance sheet.
What does a high price-to-book ratio mean?
A high price-to-book ratio historically and compared with its industry average means one of these things or a combination of them:
- The company is expected to grow
- The industry is growing
- It is a high-quality business
- It has a high return on equity
- The market is extremely positive about the company
What price-to-book is too high?
A P/B ratio can be too high if it is above the company’s historical price-to-book ratio, and if is also high when compared with the industry average and median, and the current S&P 500 average.
Do you want the price-to-book ratio to be high or low?
While the price-to-book ratio can be useful in assessing whether a stock is overvalued, fairly valued or undervalued, it is not enough on its own. The reason is that investors need to consider other aspects to make an informed decision.
Consider this example:
Stock A has a P/B ratio of 1, and a return on equity of 10%, while its industry average P/B is under 1.
Stock B has a P/B ratio of 3, a return on equity of 30%, and its industry average P/B ratio is over 3.
Which of these stocks is overvalued?
While at first glance it may seem like stock A is undervalued, a close look at all the other metrics indicates that stock B seems to be the best investment of the two.
Conclusion
While the price-to-book ratio can be an extremely important metric for stock investors, it can never be used independently to make investment decisions. A good price-to-book ratio for stock needs to be determined by comparing it with the industry, and market average, while also having an industry comparison.
