What is PB Ratio and how it can be used to analyze a stock?

PB (Price to book) ratio: All you need to know.

If you are new to the stock market or if you already have some experience buying stocks, I am sure that you will definitely think twice before investing or buying shares of a particular company or industry and you most certainly should. The reason why is that the stock market is ever-changing and we can only predict the outcome to a very minimum extent. The best example is the effect of covid-19 on the stock market this year. If you are an experienced investor, I am sure that you might be familiar with the terms or rather factors PE ratio and PB ratio. If not then don’t worry, we at Invest-ology are here to help you. In this article let us learn about the PB ratio. Why it is essential and how it will help you invest better.

What is PB (Price-to-Book) ratio?

The price-to-book (PB) ratio essentially draws a relationship between the market capitalization of an organization and the value of assets it possesses. A more apt description would be that the PB ratio is used to compare a stock’s market value with its book value (accounting value). 

PB ratio = market price per share/book value per share

Book value per share = (Total Assets – Total Liabilities) / Number of outstanding shares

Confusing isn’t it? Let me break it down for you further. Let us first understand the “book value”.

Have you ever thought about what a company is actually worth and what is its correlation to its stock price? Well, book value gives you exactly that. Book value reflects the company’s worth and can be obtained as “its assets minus the liabilities”. 

For example, say you have invested in a company and it was to shut down completely then, the book value is how much would be left with the company after all the outstanding obligations are paid off and all the assets are sold. 

Don’t get me wrong the book value is not the ultimate tool to analyze a company’s stock value. A company that is performing very well in the current market scenario is more worth than its book value because it has the ability to generate revenue and grow.

Coming back to the PB ratio, let's see an example to understand it better.

Calculation of PB ratio: 

Suppose a company XYZ has listed RS. 10,00,000 worth of assets, and Rs. 5,00,000 as its liabilities in the balance sheet. Then,

Book Value = 10,00,000 – 5,00,000 = 5,00,000

If there are 10,000 outstanding shares then the Book value per share is Rs. 50. If the market price of the stock is RS. 55 then the PB ratio is 1.1.

Also read; What is PE ratio?

Interpretation of PB ratio

Usually, the market value of a company is higher than its book value and therefore, results in a ratio higher than one. However, the converse can also be true.

A PB ratio of below 1.0, indicates an undervalued stock. However, some financial analysts and experienced investors also consider the value under 3.0 as a “good PB ratio”. The actual “good PB value” varies across industries.

Is the PB ratio useful to you?

Yes, it is useful to some extent if you know “your market”. If you are always on the lookout for low-priced stocks that the market has neglected then the PB ratio helps a lot. If the PB ratio is less than 1.0, it indicates that either the market believes the stock value is overstated, or the company is doing badly in terms of return on its stock.

You will be surprised to know that many investors have successfully used the PB ratio to dig up dormant stocks, held them over the long term, and booked good profits.

Also read : Investing expectations vs reality.

What does PB ratio indicates?

PB ratio indicates the value of the market share of a company relative to its book value. It means that PB ratio of a certain stock can tell you what is the state of the company and if whether it is able to generate good cash flow.

It can also tell is a stock is overvalued or undervalued.

Basically, it is a ratio of ‘market value of share’ to the ‘book value (net worth) of the company.

What is a good PB ratio?

Usually if any value under 1.0 is considered as a good PB ratio because, for the value of ratio to be less than 1.0, the book value of company must be greater than its market value (stock price). A good book value may indicate that the company has got good assets and less outstanding debts and has a potential of generating good amount of profit. Therefore, stocks with a PB ratio less than 1.0 can be considered as undervalued or potential stocks.

According to industry standards a PB value less than 3.0 can also be considered as a good PB value.

PB values above 3.0 indicate that the market value (stock price) of the company is more than its net worth. Now, this statement can lead to two conclusions.

The first is, the company is doing very badly in terms of revenue or has got many outstanding debts which drastically reduce the net worth of the company, making their stocks overvalued (more costly than they should actually be).

The second point of view is, the companies which own ‘intangible assets’ cannot consider these assets for calculating its net worth and thus have a low book value. But that does not mean that its stocks are overpriced. Consider an example, suppose an R&D company innovates something and patents it, then it can generate royalty revenues from that patent, hence increasing its market value (thus, the stock price).  

Therefore, the value of PB ratio alone can't tell you all the history and current state of the company, it is equally important to consider other factors too.

Also read ; Top 10 richest people in the world 2021.

Limitations of using the PB ratio

As good as an analyzing tool it may be, the PB ratio has its own drawbacks. 

Since, the declared value of assets of a company in its balance sheet is a significant aspect while calculating the PB ratio, the “kind of assets” becomes very important.

Companies such as manufacturing firms, banking sectors, and financial institutes have what we call “tangible assets” meaning the book value of its assets is comparable (almost equal) to the true value.

The problem comes for the companies with “intangible assets” meaning the assets which cannot be accounted for in the balance sheet. For example, for the companies whose biggest assets are “idea innovation”, or “patents”, the PB ratio for such companies will be misleading and we cannot judge the actual worth of the stocks of these kinds of companies with PB ratio.

Also, the book value only considers the purchase price of the asset and not its market value. So, for a manufacturing company that bought its equipment some 10 years ago which serves as its assets, its asset price is stagnant at the purchase value even after 10 years.

We mentioned earlier that a low PB ratio indicates undervalued stocks which is true but it could also mean that there are fundamental problems with the company because of which it is hiding its earnings. In which case, the investor has to go through the history of stocks of the company and figure out whether the company is hiding something or the PB value is true. 

Hence, it is better to not only just focus your attention on PB ratio while hunting for stocks, rather explore some other factors such as PE ratio and return-on-equity (ROE).

Also read : How to choose your first stock?

The final verdict

The idea of ‘buying at a low price’ and ‘selling at a high price’ has ever increased the number of investors in the stock market. If you are one among them and want to multiply your hard-earned money then the process of buying stocks at low price and selling at high price certainly works well along with the idea of ‘long-term investment’. But certain technical parameters ratios and numbers will definitely help you invest better. PB ratio is one such technical parameter (essentially a ratio). It works as a useful tool to compare the company’s market capitalization to its book value. But establishing a standard and acceptable Price-to-Book (PB) ratio is difficult as it varies by industries and sometimes a lower PB value may mean that there may be fundamental problems with the company.