Looking for a quick and easy way to assess a stock? One of the easier valuation ratios to calculate, the Price-to-book Ratio is used to determine the difference of a stocks’ market price to its book value of equity.

By comparing the resulting ratio, investors can get an indication of how the market is currently valuing the company. Although the P/B ratio has severe limitations, studies have repeatedly shown that stocks with low Price-to-book ratios consistently outperform stock with high Price-to-book ratios.

A low P/B ratio could therefore be a first indicator that a stock is undervalued. The key term here is ‘low’; to determine if a stock’s P/B ratio is low, you have to compare it against direct industry competitors.

As with most financial ratios, the benchmark for when the ratio is high or low is different when compared across different industries. It is therefore recommended to only compare P/B ratios within the same industry, at the same time and in the same country. This will make your analysis significantly more reliable.

What is the P/B Ratio?

When a company goes public, it offers its shares to investors at a price that should be representative of the intrinsic value of the firm, this is called an Initial Public Offering or IPO. During an IPO, the company sells shares of the company in order to raise capital. The IPO price, or the price at which stocks are initially offered, is based on how much money investors belief the firm will be able to generate in its entire life, where future earnings are discounted for inflation.

After the first shares are sold, the market will begin to adjust either up or down depending on whether investors are willing to pay more or less than the initial price set by the company. This will cause the price of the stock to fluctuate.

After the company has sold all its shares, the IPO is done and the majority of trading will happen between investors. Because the company is no longer involved in the trading process, the market price will move towards a level that represent the current valuation of the company by investors.

For accounting purposes, companies record an arbitrary book value for stocks. When a stock is sold, this book value plus any capital gain that the company made on the sale are recorded as part of equity. When those numbers are totaled for all stocks, the company can calculate its basic equity from the sale of stocks. This number is heavily influenced by various other factors such as retained earnings, stock buybacks and new stock issues.

To quickly calculate the current book value of equity, you simply deduct total liabilities and intangible assets* from total assets. The remainder is the current book value of equity. Divide this number by the total number of common shares outstanding and you’ll find the book value of equity per share.

The distance between the market price of common stock and the book value is what is important here,

If the market price deviates from the book value, for better or worse, the resulting difference indicates how much investors trust the company to use equity to generate earnings.

This is where the P/B ratio comes into play,

The Price-to-book ratio tells us how much the current market price of a stock is deviating from the companies’ book value of equity. It is therefore the ideal measure to determine investor confidence in the companies’ ability to generate a healthy return.

* Intangible assets are assets that are non-physical in nature. These assets are difficult to quantify and the amounts listed on balance sheets are often unreliable. Examples of intangible assets are good will, patents, trademarks, copyrights and brand recognitions. When calculating a P/B ratio you should deduct intangible assets from total assets when calculating the book value of equity. If you know, or suspect, that intangible assets are responsible for a significant portion of the returns earned by the company, calculating a P/B ratio is pointless because the book value of equity will have a smaller influence on future returns.

How is the P/B Ratio calculated?

To calculate the P/B ratio of a publicly listed company you will need the current market price and the current book value of equity. The current market price of the stock should be easy to find, as it is widely reported throughout the financial media.

To find the current book value of common stock, you will have to run some calculations. At the time of the IPO, the book value of equity was the aggregate of all capital raised from the sale of shares. Over the years, the book value of equity will be affected by earnings, dividend payments and stock buybacks; which is why the starting book value is different from the current book value. To quickly calculate a companies’ book value of equity, you have to subtract the companies’ total liabilities and intangible assets from its total assets. For example, if a company has 200 million in assets, approximately 5 million in tangible assets and 120 million in liabilities, the current book value of equity will be 75 million. With 30 million share outstanding, each share would represent RM 2.50 of book value. Once you have both the market price and the book value, you can calculate the P/B ratio. Divide the market price by the book value: If the current market price of the stock is RM 10, the P/B ratio is 4. (10/2.5) A P/B ratio of 4 means that the stock price is 4 times higher than the book value of equity per share.

How to interpret the P/B Ratio

The P/B ratio can be used to find low-priced stocks that the market has overlooked. When a company is trading for less than its book value, there can usually be two explanations:

Investors are paying less than RM 1 for every RM 1 of equity, which could mean that investors believe that the assets, as presented on the balance sheet, are overstated. If actual assets are lower than presented, total book value of equity is also lower because liabilities remain constant and assets – liabilities = equity. If this is true, you should refrain from investing in the stock because the stock is likely going to see a downwards price correction which would bring the current market price more in line with the value that investors attach to the companies’ equity.

A low P/B ratio could also indicate that investors expect the company to generate a very low or negative return on its equity. If the company is not using its assets effectively, there is a decreased chance of positive investment return in the future. However, the effective use of assets is dependent on the companies’ management or specific business conditions. If these were to change, for example if the companies came under new management, investors sentiment could change and the stock price could actually appreciate.

The challenging part is identifying which of these two scenarios is the reason for the low P/B ratio. You could gain more insight by finding the companies’ current return on equity and benchmarking the companies’ other earnings ratios against industry competitors.

On the other hand, a company with a relatively high P/B ratio is likely earning a very high return on its equity. This metric could already be factored into the stock price, and therefore it is unlikely that further appreciation of the market price will occur. For example, if a company has a monopoly it could charge a higher price for its services and generate a higher return on equity. Some industries might naturally have higher P/B ratios than others. For example, industries with a lot of growth potential will have higher P/B ratios because their stocks are inflated in anticipation of future growth.

As you can see, the P/B ratios can be interpreted in many different ways. This is why it is not recommended to use the P/B ratio as an isolated metric of value. It is best used as a preliminary test to identify areas of the business that require further investigation before any investment decision is made.

A sector where the P/B ratio can be very insightful is the banking industry. Within financial service companies, the majority of assets are relatively liquid. The market price of the assets are therefore easily retrievable. This makes the balance sheet of a bank much more reliable than for example an internet company that is much less capital intensive. To put the P/B ratio in practice let’s take a look at the P/B ratio of a few of Malaysia’s biggest banks.

When using the P/B ratio to pick stocks you will need to look for one of two things that could indicate a possible opportunity:

• A low P/B and a high Return on Equity could mean a buy.
• A high P/B and a low Return on Equity could mean a sell.

As can be seen in the table above, P/B ratio and return on equity are correlated. A company that has a higher return on equity will have a higher P/B ratio. To find undervalued stocks, we need to find stocks that have relatively low P/B ratios compared to how high the ROE is. To compare this we can calculate a ratio that quantifies the difference by simply dividing P/B by ROE:

As can be seen in the table above, Hong Leong Financial has the lowest P/B/ROE from the five banks. This is because its P/B is lower than its ROE would warrant. This could indicate that Hong Leong Financial is undervalued.

Limitations of the P/B Ratio

Despite the straightforward and intuitive feel of the P/B ratio, it has several limitations:

• The P/B ratio is not applicable when comparing companies that use different accounting standards in terms of recording equity. Even though global accounting standards have been rapidly converging over the past decade, there is still a lot of variation in how companies record their equity under various accounting systems. This could seriously skew the P/B ratio and lead to unreliable results at best and disastrous investment choices at worst.

• P/B ratios are basically useless when comparing companies that are primarily driven by intangible assets. Historically, a companies’ most valuable assets were always tangible. However, with the digital revolution came a lot of innovative companies that are largely driven by intangible assets. Companies such as Apple and Google benefit immensely from intangible assets such as intellectual capital and internally generated goodwill. These are usually difficult to quantify and this can lead to a distorted view of the value that the company derives from its equity.

• If the book value of equity has become negative, for example through a period of negative earnings, calculating a P/B ratio is meaningless. Companies can have a negative book value of equity for a number of reasons, not necessarily bad. However, calculating a P/B ratio is meaningless in this case, because the company is clearly not driven by equity.

• If a company has a high financial leverage, the P/B ratio becomes unreliable. The more debt a company has relative to its equity, the less important equity becomes. If equity is just a small part of the way the company funds its acquisition, the book value of equity has a weaker correlation with return on assets. And since equity is the basis of the P/B ratio, the ratio might be unreliable. 

What you need to remember

• The P/B ratio is calculated by dividing the current market price of a stock by its book value of equity per share.

• The P/B ratio indicates how effective investors expect the company to be with its equity.

• The P/B ratio has practical limitations and should only be used as a preliminary test to identify areas of the business that require more analysis.

The P/B ratio can be a great start in your assessment of a stock. To help you analyze your stocks even better, we did an article on How to use the Price-to-earnings Ratio. Generating consistent returns as an active trader is not easy, but it is definitely possible. If you want to amplify your returns, you are going to need a substantial capital base. One of the ways you can grow the capital available to you is through a personal loan. You can use our free comparison tool to find a personal loan that suits your needs.

About the writer

Jesse is a Guest Writer at CompareHero.my. A business student with a passion for finance and football, he is interested in new cultures and stepping out of his comfort zone.

CompareHero.my strives to empower Malaysians with financial literacy and the tools to make better financial decisions in life. Find and compare the best credit cards, personal loans and broadband plans on CompareHero.my today.

The post Investing Basics: How to use the Price-to-book Ratio appeared first on Financial News and Advice in Malaysia.