P/B or Price To Book Ratio is calculated to compare market price of a stock with its book value. Its calculated by dividing current market price of the share by the book value per share. Its also called as market-to-book ratio.
Investors widely used P/B ratio to find out hidden gems which are low priced but has exceptional return potential. To calculate, you are first required to find out book value per share or BVPS.
P/B or price to book ratio = market price per share / BVPS
Book value is also called shareholder’s equity or net worth or net asset of a company. Its calculated by dividing the net assets of a company by average number of shares outstanding. Net asset is the difference between company’s total asset and total liabilities, which come from the balance sheet.
BVPS = (total assets – total liabilities ) / average number of shares outstanding
In other words, if the company is liquidated as on the balance sheet date, then after paying all of its liability out of assets, the balance amount remaining would be shareholders equity.
Importance of P/B or Price to Book Ratio
Price to Book ratio indicates whether a share is undervalued or overvalued. For instance, if P/B is less than one, then it indicates that stock of the company is currently trading at lower than the net asset value.
Similarly, if the P/B is more than one, then it indicates that the net asset value per stock of the company is lower than its market rate as investors are expecting the company to create more value in future.
Price to book value also indicates the extra premium you are going to pay to buy a stock in comparison to company’s underlying balance sheet value. If you are expecting any undervalued company’s profit or earnings to go up in future, then you can invest in it to get good return.
Company’s P/B ratio can also be less than one when market expect the earnings to go down or the company is in financial distress or at the time of economic instability.
You should not use P/B ratio as the only parameter for your investment decisions as low Price to book value does not always mean that the stock is undervalued and you should invest in it. You have to go deeper to analyse the reason for its undervaluation. Analyst might be thinking that the future earnings will go down or it may happen that the valuation of the assets has come down due to market situation.
Total asset = Rs. 500
Total liability = Rs. 250
Number of shares outstanding = 50
Market price of the share = Rs. 10
To calculate P/B, we first have to find out BVPS of the company.
BVPS = (total asset – total liabilities)/number of shares outstanding = (500-250)/50 = 5
P/B ratio = market price per stock / BVPS = 10/5 = 2
In our case P/B is 2. This means company’s stock is trading at two time of its net BVPS.