Price to Book Ratio Explained
Among the many metrics investors use to look for value stocks, the price to book ratio is one. In this article, we will provide a price to book ratio definition, demonstrate how to calculate price to book ratio and explore how it can be used but, also, why its uses have limitations.
Table of Contents
What Is the Price to Book Ratio?
The price to book, or P/B, ratio is one of the metrics used by investors to value stocks and to help identify potential investment opportunities. The ratio expresses a company’s current market value in relation to its book value.
| P/B Ratio = Share Price / Book Value per Share |
But what is the book value of a company? And how is it calculated?
Book Value Meaning
A company’s book value is calculated by subtracting its total liabilities from its total assets. Essentially, it tells you how much money would be left to pay shareholders if the company was liquidated and its liabilities settled.
The information necessary to calculate a public company’s book value can be located on its balance sheet, which can be found in its latest earnings announcement. Another way of calculating book value is by adding up all the items in the shareholder equity section of the balance sheet.
Above is a screenshot of Amazon’s balance sheet from its 2023 fourth quarter earnings announcement.
Highlighted in red are its total assets and its total liabilities. If we subtract the latter from the former, we can calculate that, as of 31 December 2023, Amazon’s book value was $201,875 million. You will note that, as mentioned previously, this figure is the same as the total stockholders’ equity, which is highlighted in blue above.
Price to Book Ratio Calculation
So, in order to calculate price to book ratio, we need to divide the current share price by the book value per share. In order to find book value per share, we simply divide the book value by the number of shares outstanding (something which can also be found in a company’s earnings report).
In the case of Amazon, based on the information above, as of 31 December 2023, its book value per share was $19.49.
To remind ourselves of the price to book ratio formula, in order to find P/B, we must divide current share price by the book value per share. At the time of writing, Amazon’s most recent closing price was $176.55.
These figures result in a price to book ratio of 9. But what does this tell us?
Price to Book Ratio Interpretation
As we said right at the beginning, the P/B ratio expresses a company’s current market value in relation to its book value. Consequently, a P/B ratio of 1 means a stock is trading in line with its book value.
A price to book ratio less than 1 means that a stock is trading at a discount to its book value, whereas a price to book ratio of more than 1 means that a stock is trading at a premium to its book value. This could mean that the stock in question is undervalued or overvalued respectively.
In the case of Amazon above, its P/B ratio tells us that the market currently values the company nine times higher than its book value.
Typically speaking, for an investor, the lower the P/B ratio, the better. If a stock has a price to book ratio less than 1, this might make it a more attractive investment for value investors, who specifically target undervalued stocks.
However, as with many financial ratios, the P/B ratio of one company in isolation doesn’t give us too much to go on. Investors will tend to compare a company’s P/B ratio to those of similar companies which operate in the same industry. In this manner, they are able to tell if the market under or overvalues the company compared to its peers.
For example, if the average price to book ratio of Amazon’s competitors was 5, then Amazon’s P/B ratio of 9 tells us that Amazon is valued higher than its peers. This could imply that Amazon was overvalued.
However, we should be wary of drawing too many conclusions from this type of analysis. Investors shouldn’t base investment decisions on one metric and should seek other data to back up any findings from using the price to book ratio.
Drawback of Using the P/B Ratio
Whilst the price to book ratio can be useful when evaluating a company, it’s important to recognise its shortcomings.
Mainly, the P/B ratio is only really considered useful when valuing capital intensive businesses which have significant investments in tangible assets, such as property companies, transport companies and financial businesses such as banks.
For many modern companies, particularly technology companies such as Amazon, there is not much correlation between intrinsic value and book value. This is because a lot of these companies’ assets are intangible – such as intellectual property rights or brand value - and are not fully accounted for in the balance sheet.
For example, Amazon’s book value does not account for the significant value of its world famous brand and logo. Both of these help give Amazon an edge over its competitors and, consequently, contribute considerably to its intrinsic value.
This results in book value that understates intrinsic value, which is part of the reason why you will find that market value very often exceeds book value.
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FAQ
What is the book value of a stock?
A company’s book value is the difference between its total assets and total liabilities.
What is a good price-to-book ratio?
Generally speaking, the lower the price to book ratio, the better. A price to book ratio below one may suggest a company is undervalued, making it desirable to value investors. However, to fully understand the P/B ratio of a company, it should be compared to that of other companies in the same industry.
What does a high P/B ratio mean?
A high P/B ratio could mean that a company is overvalued, but it is important to explore other metrics before drawing this conclusion. Generally, if a P/B ratio is higher than 1, it means that the market values the company higher than its book value.
What does a negative P/B ratio mean?
A negative P/B ratio means that a company’s total liabilities exceed its total assets.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
