P/B ratio

The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's current market value to its book value (where book value is the value of all assets minus liabilities owned by a company). The calculation can be performed in two ways, but the result should be the same. In the first way, the company's market capitalization can be divided by the company's total book value from its balance sheet. The second way, using per-share values, is to divide the company's current share price by the book value per share (i.e. its book value divided by the number of outstanding shares). It is also known as the market-to-book ratio and the price-to-equity ratio (which should not be confused with the price-to-earnings ratio), and its inverse is called the book-to-market ratio.

As with most ratios, it varies a fair amount by industry. Industries that require more infrastructure capital (for each dollar of profit) will usually trade at P/B ratios much lower than, for example, consulting firms. P/B ratios are commonly used to compare banks, because most assets and liabilities of banks are constantly valued at market values. A higher P/B ratio implies that investors expect management to create more value from a given set of assets, all else equal (and/or that the market value of the firm's assets is significantly higher than their accounting value). P/B ratios do not, however, directly provide any information on the ability of the firm to generate profits or cash for shareholders.

This ratio also gives some idea of whether an investor is paying too much for what would be left if the company went bankrupt immediately. For companies in distress, the book value is usually calculated without the intangible assets that would have no resale value. In such cases, P/B should also be calculated on a "diluted" basis, because stock options may well vest on sale of the company or change of control or firing of management.

Total book value vs tangible book value

Technically, P/B can be calculated either including or excluding intangible assets and goodwill.[1] When intangible assets and goodwill are excluded, the ratio is often specified to be "price to tangible book value" or "price to tangible book". See also Return on tangible equity.

Applications and limitations

In the 1920s and '30s when investors like Benjamin Graham outlined the concepts of value investing and estimating a company's value, book values were more relevant than in later years. Most companies in this era had significant investments in tangible assets, and such assets comprised the bulk of the value of the company. The value of today's companies, other than asset based companies like investment trusts and property companies, is very different from the book values and there is often no relationship between their intrinsic values and their book values. In his 2000 annual report, Graham disciple Warren Buffett said "In all cases, what is clear is that book value is meaningless as an indicator of value".[2][3]

Except in the case of a small minority of companies, like property companies and investment trusts that are asset-based, book values can bear little or no relationship to true values of the companies. The items on a company's balance sheet are the result of various transactions, recorded using double-entry bookkeeping at a particular point in time, to the extent that they do not form part of the profit and loss account to that point in time. The assets and liabilities comprising the book value are mainly stated at historic cost though a few items therein may be stated at valuations.

In many of today's companies, their most valuable assets are not shown on the balances sheet and are therefore not necessarily reflected in the company's book value. In these types of companies, factors such as copyrights, intellectual capital, internally generated goodwill, or brand awareness are much more valuable than the tangible assets listed on their balance sheets. This generally leads the company's market value to be higher than its book value.

Despite the limitations of the price-book ratio, academic research has repeatedly shown that stocks with low price-book ratios tend to outperform stocks with high price-book ratios in the United States and other nations.[4][5][6][7][8] Eugene Fama and Kenneth French incorporated a price-book term in their influential three factor model. Penman Richardson and Tuna (2013) show how the price-to-book ratio can be decomposed into financing and operating components. Foye and Mramor (2016) show that while stocks with low price-book ratios normally outperform, the ratios decomposed elements exhibit a different relationship with returns in different countries, implying that the price-book ratio may have a country-specific interpretation.[9]

See also

References
  1. Graham and Dodd's Security Analysis, Fifth Edition, pp 318 - 319
  2. "Book values".
  3. "Filters, sieves & screes".
  4. Carlo Capaul, Ian Rowley & William F. Sharpe (1993) International Value and Growth Stock Returns, Financial Analysts Journal, 49:1, 27-36, DOI: 10.2469/faj.v49.n1.27
  5. Oppenheimer, Henry R. “A Test of Ben Graham's Stock Selection Criteria.” Financial Analysts Journal, vol. 40, no. 5, 1984, pp. 68–74. JSTOR, www.jstor.org/stable/4478776. Accessed 7 Mar. 2021.
  6. Eugne Fama and Kenneth French. The Cross-Section of Expected Stock Returns, Working Paper 333, Graduate School of Business, University of Chicago, January 1992.
  7. S. Basu. "Investment Performance of Common Stocks in Relation to Their Price/Earnings Ratios: A Test of the Efficient Market Hypothesis", Journal of Finance 32(3), June, 1977.
  8. Institute, Brandes, Value vs. Glamour: A Global Phenomenon (October 15, 2008). Brandes Institute Research Paper No. 2008-06, Available at SSRN: https://ssrn.com/abstract=1289357 or http://dx.doi.org/10.2139/ssrn.1289357
  9. Foye, James; Mramor, Dusan (20 May 2016). "A New Perspective on the International Evidence Concerning the Book-Price Effect". doi:10.2139/ssrn.2782441. SSRN 2782441. {{cite journal}}: Cite journal requires |journal= (help)

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