Stocks are one of the most vital financial instruments in the world today. Here's a guide to provide a basic understanding of one ...
If you want to learn what the price-to-book ratio is and how you can use it in your investing activities, this guide is for you.
Deciding where to invest can be particularly hard in these times as there’s a greater inflow of information. What company should I invest in? How will it perform in the future? Am I late to buy any stock shares? You’ve heard of the price-to-book ratio as an answer to these and more questions, that’s why this guide will cover all the essential information you need.
Throughout the years we have seen many tools that have helped investors, analysts, marketers, and anyone keen to explore the financial situation of a company and its industry. But the PB (price-to-book) ratio has been the preferred one among many investors and analysts in the marketplace.
Having many years of use in the finance realm, the PB ratio is essentially a way to measure how the stock price of X company is being traded and comparing it to the balance sheets, that is, the book value.
But this financial tool will work better when you know how to apply it because it doesn’t work, or at least is not effective if you use it for every industry out there.
The effectiveness of this tool is highlighted when you’re trying to invest in a company, and you need to study its behavior, likewise, if it’s a risky move to put your money at stake.
You can outline the process as easy as dividing the share price by the book value. You’ll get the P/B ratio as a result. But keep in mind that you must include the capital stocks that the company has, as well as its reserves and other assets.
So, simply put, you can obtain the P/B ratio if you divide a company’s current market price by the book value. Although, bear in mind as well that the effectiveness of this tool will mostly depend on the sector you’re applying it to. It provides greater results for industries that rely more on intangible assets, compared to hard-assets industries.
The P/B ratio can be troublesome as it has its own limitations, and analysts tend to diverge on what exactly is considered a good P/B ratio is.
Analysts can diverge on what exactly a good P/B ratio is. Usually, an undervalued stock, say a 1.0 P/B ratio, is considered a good investment as prices could surge in the future. Although, this financial ratio doesn’t provide direct information on a company’s ability to make profits in the long run.
There are several questions that could come to mind when deciding where and how to invest. What would happen if the firm goes bankrupt? How much will the company pay me per the shares that remain? Is the company in distress and excluding other assets in the balance sheets?
Likewise, the P/B has its own limitations as well. It’s not a reliable metric to calculate a company’s book value per se, and it depends on the industry.
You want to stake your capital in X firm. You need to know, or at least have a clue, how the share price behaves when he compares it to that firm’s book value, meaning, how high or how low is being currently traded? Is it depreciated or overvalued? It’s a simple exercise you can do anywhere.
X firm has a number of shares, say 10 million, and a book value of $10 million. Divide 10 million shares by the $10 million of book value = $1 per every share of X firm.
This is the current status of X firm, but you need to keep track of that ratio over the months to see how it performs and compare it to other companies.
The P/B has another interesting effect, as it allows us to compare different companies between sectors that could have a similar capital-deb structure, determining the number of times the book value reflects on the listing price. Old school investors like Benjamin Graham and Warren Buffett have compared companies to one another like this for years.
The value of the P/B ratio equals dividing the ROE (Return of Investment) by the company’s cost of equity.
This multiple is pretty much reliable in specific sectors, such as banks, for example, due to their high leverage inherent in this type of entity. On entities with high leverages, is normal to expect a higher ratio, say 2.0 or 3.0. In other cases like conglomerates, real states, and infrastructure, we generally see a result much lower than the book value.
The P/B provides you with an index so you can homogeneously compare several companies. If you need to estimate the scarcity of X company, just compare its P/B ratio with the general market
Although these differences may be derived from differences in operational and financial risks and growth, which makes the apparent situations of relative famine persistent. Thus, it is necessary to study the behavior of the relative P/B.
Investors should keep in mind that the usefulness of the data per share is broader than the simplification of the calculations, as it also consists of knowing the company’s history, what has happened with the company, and avoiding the elimination of references that cause mergers and capital increases. This would also serve in hypothetical segregations and capital reductions.
It’s harder to measure a firm’s book value today because they have evolved with time. Some decades ago, the book value had a lot of relevance because a lot of companies in several sectors had more hard assets, like pieces of land, for example.
But now intellectual capital and all the intangible assets they generate are more profitable since there’s a change in the industries thanks to the evolution of technology. Think about Intangible valuations as are more valuable to certain companies like Apple or Microsoft, paving the road for greater market value (and making the book value irrelevant).
Now you might have run across these two concepts. The Equity Market, in short, is the total market capitalization of a company. Nowadays the market cap for big companies like Apple or Tesla is greater thanks to brand awareness, customer’s needs, and intangible assets like intellectual capital, hype, goodwills, etc.
To differentiate these concepts, think about the book value as the display every company has to make to know how they perform on a certain period. These are called balance sheets. The book value also works as an indicator of how a stock is performing in the market.
With the PTBV (Price-to-Tangible-Book Ratio) we’re talking about hard, tangible assets. These hard assets are usually real states, precious metals like gold and silver, commodities, etc.
Companies in service-oriented businesses don’t apply for this type of measurement. Think about the tech sector: the inherent value of this sector relies on all kinds of intangible property, mainly aimed at customer’s needs and centered only around them.
The P/B ratio, despite being used for a long time to get an idea of how a company is behaving in a given period, is not a perfect tool that can be applied to any type of industry. You have to know where to apply it, as has been stressed before, only then will you achieve good results and you can invest your capital with less risk.