Price-to-book ratio (P/B)

A simpler – albeit slightly more crude way than using discounted cash flow – of gauging whether a company's shares are underpriced or overpriced is by looking at its price to book (P/B) ratio.

This is calculated by dividing the current closing price of a company's share by its book value per share in the latest quarter. A company's book value can be arrived at by subtracting its intangible assets and liabilities from its total assets.

First work out the book value:

Book value per share = total assets minus intangible assets and liabilities / number of shares

Then you can work out the price-to-book value:

P/B = share price / book value per share

For example, if a company has £200 million of assets on its balance sheet and £150 million of liabilities, it will have a book value of £50 million. If it has 10 million shares, its book value per share would be £5.

If the same company's shares are currently trading at £2.50, it would have a price to book ratio of 0.5. If its shares are currently at £10, it would have a price to book ratio of 2.

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A price to book ratio lower than one can mean the company is undervalued

A price to book ratio of less than 1 suggests that the market is valuing the company at less than the total value of its assets. This means that its shares may currently be undervalued or cheap and therefore present a good buy opportunity.

Be careful however. There may be a justified reason for investors assigning a low value to the company. It could simply mean that the company is earning a very poor, or even negative, return on its assets. Operational inefficiency like this could be a reason for selling, or avoiding, this company's shares.

Take a look at how much debt a company has before you let the price to book ratio determine whether you buy or sell a share. A heavy debt load can produce an artificially high ratio.

Caution when considering high price to book values

Similarly, a high price to book ratio of 3 or 4 can indicate that a company is overvalued, encouraging you to sell its shares. Once again, this is a very useful indicator, but you should exercise caution.

If the company has just released a hot new product or has become a takeover target, there could be a fundamental reason why its share price appears too high.

A high price to book ratio of 3 or 4 can indicate that a company is overvalued, encouraging you to sell its shares.

Consider the hard assets of the company

The price to book ratio is also less useful at analysing businesses that may not have a large amount of hard assets, such as factories or expensive equipment, but do have other intangible assets such as intellectual property or a powerful brand name that have a real value but can be hard to price.

For this reason, price to book ratios differ from industry to industry.

Also, take a look at how much debt a company has before you let the price to book ratio decide for you whether to buy or sell a share.

If a company has a heavy debt load, the asset figure used in the calculation will be very small and this can skew the price to book ratio produced. If the money it has borrowed is generating a greater return in terms of profit and future growth than it costs to borrow it, the company's high price to book ratio is artificial and can sometimes be ignored.

Summary

So far you have learned that...

• ... price to book is a simpler way, than using the discounted cash flow, of gauging whether a company's shares are underpriced or overpriced.
• ... a price to book ratio of less than 1 suggests that the market is valuing the company at less than the total value of its assets.
• ... a high price to book ratio of 3 or 4 can indicate that a company is overvalued, encouraging you to sell its shares.
• ... the price to book ratio is less useful at analysing businesses that may not have a large amount of hard assets such as factories or expensive equipment, but do have other intangible assets such as intellectual property or a powerful brand name that have a real value but can be hard to price.
• ... if a company has a heavy debt load, the asset figure used in the calculation will be very small and this can skew the price to book ratio produced.
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