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Tuesday, July 11, 2017

Price to Book Ratio (P/B Ratio)


P/B Ratio

The price-to-book ratio (P/B Ratio) is a ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share. A lower P/B ratio could mean that the stock is undervalued.

P/B Ratio is used in value investing.

P/B Ratio = market capitalization / book value of equity.

(Market capitalization is often abbreviated as "market cap"; book value is often abbreviated as "BV")

Market capitalization = shares outstanding * market price per share

Book value of equity = book value of assets - book value of liabilities

So therefore, P/B = market cap / (BV of assets - BV of liabilities)

From Wikipedia:
In Benjamin Graham's days, book values were more relevant as most companies then 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 no relationship between their intrinsic values and their book values. That is why Warren Buffett said "In all cases, what is clear is that book value is meaningless as an indicator of value" in his 2000 annual report.
Except in the case of a small minority of companies like property companies and investment trusts that are asset based, book values bear little or no relationship to true values of the companies. The items on the balance sheet are the result of various transactions, recorded using double entry 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 included in the book value. Book values are meaningless in companies such as Apple, Microsoft, Google, Facebook, GlaxoSmithKline, etc. where their intellectual capital, internally generated goodwill, etc. are much more valuable than the assets per their balance sheets but are not included therein.
As with most financial ratios, the P/B ratio has certain limitations. It is said to be useful only for capital-intensive companies or businesses that have large amount of book value assets. It does not take into account intangible assets such as patents, goodwill, and other forms of intellectual property that the business has developed. Therefore, for those with minimal tangible assets like services companies, the P/B value does not have much meaning. For companies like Microsoft, the stock price carries little bearing on the company’s book value because the bulk of its assets are on software products which are intangibles.

By comparing book value of equity to its market price, we get an idea of whether a company is under- or overpriced. However, like P/E or P/S ratio, it is always better to compare P/B ratios within industries. 

The P/B ratio varies depending on the industry so exercise caution in doing outright comparison. Companies that have more intangible assets have P/B ratios that are normally higher than the traditional ones that have more tangible assets. Check its limitations so that you won’t arrive at the wrong conclusions.

What if P/B ratio is less than one?

With a P/B ratio less than one, the stock is trading at a value lower than its book value. This is so because the market thinks the company’s asset value is overstated. If this is true, investors are advised to shy away from this company because it is likely that it will face a downward adjustment or correction in its price by the market. This can leave investors with losses. But a P/B ratio less than one can also mean that the company is earning very low returns from its assets and these is a chance that an adjustment in management, for instance, can lead to a turnaround in prospects and show positive gains.
A P/B ratio less than one means that the stock is trading at less than its book value, or the stock is undervalued and therefore a good buy. Conversely, a stock with a ratio greater than one can be interpreted as being overvalued or relatively expensive.
A P/B ratio less than one can also mean that the company is earning weak or even negative returns on its assets, or that the assets are overstated, in which case the stock should be shunned because it may be destroying shareholder value. Conversely, the stock’s share price may be significantly high – thereby pushing the P/B ratio to more than one – in the likely case that it has become a takeover target, a good enough reason to own the stock.

What does a high P/B ratio represent?

A higher ratio is a reflection of higher expectations of the company’s future gains. This may be attributed to perceived growth prospects or lower risks associated with the stock. However, a higher P/B ratio also reflects that the stock is relatively more expensive than it used to. During a bubble for instance, a high P/B ratio indicates over-optimism. Any new information or good news about the company may have been accounted for in the current price.

Take Note:

Moreover, the P/B ratio isn't without its limitations. It is useful for businesses – like finance, investments, insurance and banking or manufacturing companies – with many liquid/tangible assets on the books. However, it can be misleading for firms with large R&D expenditures or high-debt companies or service companies or those with negative earnings.

In any case, the P/B is not particularly relevant as a standalone number. One should also analyze other ratios like P/E, P/S, and debt to equity before arriving at a reasonable investment decision.

How is this ratio used?

This ratio is known in value investing strategy.  Investors usually choose stocks that have P/B ratios not higher than 3.  This level signals a perfect timing to buy since the stock seems to be selling at a discount. You have to dig deeper into this low ratio or it might be an indication that something is wrong with the company.
The P/B ratio may be widely used but it should not be used as a sole gauge to find undervalued stocks. It is often analyzed alongside the return on equity (ROE) which is an indicator of profitability. A higher ROE means that more money is being produced by the company given the same level of equity.  For a company that has a rising ROE, its P/B ratio should also rise. This is understandable because investors will get attracted to a stock that is producing more profits.  A sign that the stock is overvalued, which tells you that you won’t be making a lot of money out of it, is when you see a company that have very low ROE but high P/B ratio. Therefore, when you are evaluating the value of a company, take the P/B ratio and ROE analysis hand-in-hand.
The notion of book value also does not have much meaning for companies with sustained losses and large amount of borrowings. Because the denominator is the difference between book value assets and book value liabilities, one which has very high debt would have a very small denominator which can drive the P/B ratio at a very high level. Such is the case of cable and wireless telecoms companies. Meanwhile, for companies that incurring sustained losses, the book value becomes meaningless as it takes a negative value.
Also, the book value may fail to present the real value of aging assets especially at an environment of high inflation as the assets’ earnings power has already declined since these were obtained. This also applies to the case when the assets are no longer operating or have increased in value due to some reasons.
Other things that can distort the P/B ratio include share buyback because this cuts the company’s capital on its balance sheet. When businesses improve or reduce their cash reserves, they alter the book value without causing changes in operations. When they put these into a pension plan for instance, the book value will fall.

Screening Parameters (from Zacks)
Price to Book (common Equity) less than X-Industry Median: A lower P/B compared with the industry average implies that there is enough room for the stock to gain.

Price to Sales less than X-Industry Median: The P/S ratio determines how much the market values every dollar of the company’s sales/revenues — a lower ratio than the industry makes the stock attractive.

Price to Earnings using F(1) estimate less than X-Industry Median: The P/E ratio (F1) values a company based on its current share price relative to its estimated earnings per share – a lower ratio than the industry is considered better.

PEG less than 1: PEG ratio links the P/E ratio to the future growth rate of the company. PEG ratio portrays a more complete picture than the P/E ratio. A value of less than 1 indicates that the stock is undervalued and investors need to pay less for a stock that has a bright earnings growth prospect.

Average 20-Day Volume greater than or equal to 100,000: A substantial trading volume ensures that the stock is easily tradable.

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