When analyzing stocks or companies to invest in, there are different ratios for gauging financial health. The price-to-book ratio (P/B) is one way to evaluate a stock’s value, something that may be important if you’re looking for ones that are undervalued to invest in. A value investing strategy focuses on finding companies that have solid return potential but may be overlooked by the broader market. This ratio, along with other key ratios, can help guide your investment decision-making. For hands-on help evaluating whether an investment is right for you, consider finding a financial advisor in your area.
Price-to-Book Ratio, Definition
Price-to-book ratio, in simple terms, is a way to measure the market value of a company against its book value. Market value refers to market capitalization, or the stock’s current per-share price multiplied by the number of outstanding shares being traded. Book value is the difference between what the company has in assets and what it’s carrying in outstanding liabilities.
This ratio can be used when comparing stocks to decide where to invest. If you’re specifically looking for stocks that are undervalued, price-to-book ratios can be helpful for making apples-to-apples comparisons between companies that have similar growth and profitability profiles.
You might also use price-to-book ratios to compare companies in situations where other ratios prove less reliable measures of financial health. For instance, if you’re eyeing a company that reports inconsistent earnings, then looking at the price-to-earnings ratio alone may not give you an accurate picture of a stock’s value.
How to Find Price-to-Book Ratios
There are a few steps involved with finding P/B ratios, though it’s not an overly complicated process. To calculate the price-to-book ratio of a stock, you’d first need to know the company’s book value. Again, this is assets minus liabilities, and it can be found by reviewing the company’s financial statements, such as a balance sheet or annual report.
From there, you’d determine the book value per share, which is the book value divided by the total number of outstanding shares. To find the price-to-book ratio, you’d divide the share price by the book value per share. In terms of what’s a good price-to-book ratio, it’s generally anything under 1, since that means the stock could potentially be undervalued.
So as an example, assume you want to invest in a company that has a book value of $2 billion. The company has 100 million outstanding shares, which means the book value equals $20 (2 billion/100 million = 20). If the stock is trading at $25 per share, the price-to-book ratio would work out to 0.8 ($20/$25 = 0.8), potentially making it an undervalued stock.
Using Price-to-Book Ratios to Evaluate Stocks
Looking at the P/B ratio of a stock can be beneficial from a value investing perspective if you’re trying to find the undervalued hidden gems of the market. When companies have a low price-to-book ratio, meaning they’re trading for less than their book value, it can mean that the market has underestimated what the company is worth.
This ratio can also be helpful in avoiding stocks that may look undervalued but are not good buys. For example, if a company is reporting low or negative returns then those companies may end up being value traps. A value trap happens when an investment looks like a good bargain because it’s lower-priced and has a low P/B ratio but, in reality, lacks the characteristics needed for capital appreciation over the long term.
Value traps can be dangerous because investors buy into them thinking they’ve scored a deal. But a low price-to-book ratio or low price-to-earnings ratio can be misleading if the company is not fundamentally positioned to meet performance expectations.
Potential Drawbacks of Price-to-Book Ratios
One thing to keep in mind is that using P/B ratios to measure a company’s valuation is most effective when it’s done alongside other ratios. For example, looking at return on equity (ROE) can give you a better idea of a company’s growth prospects. ROE refers to the amount of profit that’s generated from shareholders’ equity in the company. If there’s a wide gap between the two, that could hint that a stock is actually overvalued.
The price-to-book ratio also has some shortcomings in that it doesn’t take into things that can enhance or dilute a company’s book value. A stock buyback, for instance, can throw the numbers off temporarily since it likely isn’t a regular occurrence.
Another important thing to note about the price-to-book ratio is that its usefulness can be determined by the company itself. If you’re evaluating a company that has mostly intangible versus tangible assets, then it can be more difficult to get a true sense of book value and, in turn, the price-to-book ratio.
At the same time, a P/B ratio above 1 doesn’t mean that a company isn’t a good buy or is overvalued. Again, that’s why it’s so important to look at other measures, such as earnings per share, quick ratio, current ratio and return on equity to get a well-rounded sense of a company’s financials.
The Bottom Line
Price-to-book ratios can be helpful when deciding where to invest if you follow a value strategy. While a P/B ratio alone may not be the most reliable measure of a company’s value and financial health, it can offer valuable insight into where a stock may be headed. When considering where to invest, take into account things like the company’s debt levels, assets, earnings and cash flow to help you make the most informed decision possible.
Tips for Investing
- Consider talking to a financial advisor about the price-to-book ratio and how that can or should shape your investment decisions. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated or stressful. SmartAsset’s financial advisor matching tool can help you quickly connect with professional advisors in your local area. If you’re ready, get started now.
- There are different ways to evaluate stocks, including using fundamentals like P/B ratio as well as technical analysis. Technical analysis focuses more on pricing patterns and trends to determine where to invest. While the fundamental analysis may be more useful for value investing, it can also be helpful to consider the merits of technical analysis when building a portfolio of value investments.
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