What is the Price to Book Value Ratio?
The price to book value ratio, also called the PBV ratio, focuses on how much an investor must invest to gain an ownership interest in the firm. It compares the market value and the book value of a company.
Suppose a company about to be liquidated sells all its assets and pays back all its debts. Now, whatever is left over is the book value of the company.
You can calculate the price-to-book value ratio as follows:
Price/Book value ratio = Market Price per Share / Book Value per Share.
Many companies have a price-to-book value ratio greater than one, which means the market value is greater than the book value. It is because investors may pay a premium above the book value if the firm is expected to generate good earnings in the future.
Moreover, the company’s book value may not be up to date. For example, a stock with a price-to-book value ratio of three means you pay Rs 3 for every Re 1 book value.
For instance, the asset value on a company’s balance sheet may reflect the price the company paid for the asset. However, the asset may not be currently worth this price.
Understand Price to Book Value Ratio with an example:
Suppose Company ABC’s stock price is Rs 3,000 and its most current book value per share is Rs 600. Moreover, Company XYZ’s stock price is Rs 2,000, and its current book value per share is Rs 500. How will you calculate the price-to-book value ratio?
Price/Book value ratio = Market Price per Share / Book Value per Share.
The PBV ratio of Company ABC = 3000 / 600 = 5.
The PBV ratio of Company XYZ = 2000 / 500 = 4.
All other things being equal, companies with a lower price-to-book value ratio are considered attractively valued rather than companies with a higher price-to-book value ratio.
In this example, Company XYZ has a lower price-to-book value ratio than Company ABC and is attractively valued by investors. Value investors look for stocks of companies with a PBV ratio of less than one. However, the PBV ratio below three is also considered to be good.
What is the significance of the PBV ratio?
The PBV ratio helps you understand if the stock price is reasonable compared to its balance sheet. It is a vital factor for companies which are close to bankruptcy. For example, if a company is close to bankruptcy, there is no guarantee that shareholders would receive the full book value of a liquidated company.
The price-to-book value ratio is vital for companies holding tangible assets. For instance, you could check the PBV ratio for manufacturing companies with significant tangible assets such as Plant and Machinery, property etc. However, the PBV ratio is less critical for firms which consist mainly of employees, office space, computers etc., as they won’t have a meaningful book value.
Suppose a company’s PBV Ratio is below one. It means the company is trading below its book value, and its shares are undervalued. However, it would help if you looked into why the market price of the shares is below the book value.
For instance, are the company shares undervalued because the firm has suffered heavy losses, or its top management has made poor investment decisions. Hence, you should not pick company shares because the PBV ratio is below one, considering them to be value buys. It helps to find out why the PBV ratio is low.
The PBV ratio helps to value stocks if the company’s earnings are negative and the commonly used PE ratio is not applicable. It helps compare companies in an industry with consistent accounting standards. Moreover, you may use the PBV ratio to compare banks’ stocks. However, the PBV ratio finds limited use in the service sector.
When should you not use the PBV Ratio to value companies?
- As the PBV ratio considers tangible assets, you cannot use this ratio to value IT stocks. For instance, the PBV ratio increases when there are lesser tangible assets, and as IT firms have more intangible assets like patents, you will get a higher PBV ratio. It signals an overpriced stock, and you will analyse the company’s value incorrectly.
- Companies with higher debt levels on their balance sheets show a higher PBV ratio. It helps to look at other ratios, such as interest coverage ratio, which show how easily a company services interest on outstanding loans to analyse the shares of high-debt firms.
- Companies quote assets on their balance sheet at their cost price. However, firms tend to underestimate or overestimate their asset’s market price, leading to an inaccurate PBV ratio. It is a common occurrence in the cement and steel industries. Investors may look at other ratios such as the Debt-Equity ratio and PE Ratio to analyse the shares of these companies.
Conclusion:
- You may use the PBV ratio to pick undervalued stocks. However, you must check other ratios before making an investment decision.
- You could use the PBV ratio to pick stocks of capital-intensive sectors such as petroleum refineries, transport and telecommunication. However, it is vital to compare the firm’s PBV ratio against the industry PBV ratio to pick suitable stocks.
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