What is p/b ratio and its importance in stock analysis

Identifying a stock’s intrinsic value might sound intimidating, but can be easily calculated through the so-called cornerstone of stock market-the price to book value or P/B ratio. A P/B ratio helps you to understand the fair-pricing of a stock and can be an easy way out to identify stocks that might make your net worth grow with its growing price.

What is the P/B ratio?

Price to book value ratio or P/B ratio identifies the current price that an investor is willing to pay for a stock. Now by comparing this with the market value of a stock, one can easily establish if the value of that stock is overvalued or undervalued or is at its best price and can accordingly make the decision to buy/sell/hold. P/B ratio is a vital financial ratio for an investor that compares a  company’s net assets with its price to obtain a fair price of the stock. This is what makes it such a substantial and highly acknowledged ratio among  the high-end investors.

P/B ratio also known as price-equity ratio, is a highly used metric by an investor to draw a relationship between the market capitalization and the value of assets of a company. This acts as a critical agency for brokers especially so as to earn huge profits based on the underlying value of a stock. This also helps to study a market trend of a sector. 

 P/B ratio is an excellent tool to identify the stocks trading at discount, well who doesn’t like a good bargain. Hence, historically the p/b ratio has been a quintessential in identifying the outperforming stocks.

How to Calculate a P/B Ratio

While the p/b ratio of a stock is readily available in your broker's account, it is important to understand where it comes  from to make an informed decision while investing in a stock.

There are two ways by which an investor can identify a relationship between market price of a share and its net assets through price to book value ratio. While both the ways ideally provide the same value, an investor can choose his convenient formula as given below:

Price to Book Value (p/b) = Market Capitalisation / Book Value of Assets

OR

Price to Book Value = Current Market Price / Book Value per Share

The Current market price is readily available on the web or company’s website. However, an investor needs to calculate the book value per share. Book Value is said to be equal to the net assets of the company. An investor can identify the book value by taking, Book Value = (Total Assets – Liabilities – Intangible Assets) / Number of outstanding shares.

It is important to note that while calculating a company’s book value, intangible assets like patents, goodwill or other intellectual properties must not be taken into consideration.

Price to Book Value Example

Let us understand the calculation of the price to book value (PB) ratio with an example. Assume the following financials of a company X

Current Market Price = Rs 1,959

Total Assets = Rs 13,21,212 (in crores)

Total Liabilities = Rs 6,21,040 (in crores)

Outstanding Shares = 634 (in crores)

Step 1: Identifying book value per share.

Book Value/share= Total Assets – Liabilities / No of Outstanding Shares

= (Rs 13,21,212 – Rs 6,21,040) / 634

= Rs 1,104

What does a book value of Rs 1,104 imply?

It means that the investor shall get Rs 1,104 on the payment of Rs 1,959 (as market price) in case the company X goes into bankruptcy.

Step 2: Now an investor needs to calculate Price to Book value. This can be calculated by dividing a share’s current market price by book value per share.

P/B Ratio = Current market price / Book value per share

= Rs 1,959 / Rs 1,104

= 1.77:1

This implies that an investor is paying 1.77 rupees for 1 rupee of Company ‘s assets. So what can you gauge by this?

Well, to understand this you need to know the deal P/B ratio and its implications.

An ideal p/b ratio as per the trading business is less than or equal to 1. This signifies that the stock is  undervalued However, in practical terms price to book value up to 3 is generally acceptable not but not recommended. 

This tells us that company X can be an ideal choice of investment as far as p/b ratio is concerned. However it is advised for an investor to also take the market behavior into consideration before bagging their money into a stock.

Advantages of using P/B ratio

It is by now understood that the P/B ratio is certainly a useful valuation tool that helps an investor to commensurate how many times a stock is trading lower and below a company’s book value. Having said that, it is also important for an investor to look at the historic P/B ratio of a company’s stock. This can be also compared with other stocks as in the same sector or of the same industry. It is also essential to understand that an investor must not solely base his  decision to buy a share on a single valuation metric but also must take into account other valuation metrics such as P/E ratio combining which an investor can make the best investment decision possible.

Following are the added advantages of using a P/B Ratio:

• The P/B ratio is less volatile as compared to other valuation metrics. The P/B ratio is known to remain age-bound and is relatively stable than other financial ratios.
• The PB ratio is ideal for value investors. These are investors who scan these ratios  to buy undervalued stocks with the presumption that the market price of these stocks shall rise in the future and be sold at higher prices.
• P/B ratio is universally regarded as the standard of undervalued stocks. 

Tips for Investors for Selecting Stocks Based on P/B Ratio

Some of the following tips shall help you as an investor to make a well researched and au courant decision:

• An investor who wants to build a low turnover portfolio may explore the PB ratio but it is certainly not bets for the high risk players
•  A PB ratio of below 1.0 is an indicator of undervalued stock in the IT industry. In contrast, it could be regarded as negative for the oil and gas industry. Therefore while comparing the metric for a specific industry an investor must be well aware of its ideal p/b ratio.
• A low PB ratio is a dial to foundational issues of a company as far as earnings are concerned. An investor must therefore compare other metrics along with the analysis of a company’s past trends to derive a reliable conclusion.

Caution While Using Price to Book Value Ratio (p/b)

• The p/b ratio does not take into account the intangible assets in its calculation which is ideally an integral part for many tech companies. Therefore it tends to limit its ability of providing a true picture in the case of such companies.
• The book value takes most of the assets as per their acquisition value and not as power  their market value. Hence, the P/B ratio might tend to keep the valuation of a stock depressed.

Therefore an investor must be cautious and not blindly rely on one such metric while dealing with the undervalued stocks. To maximize the capital, it is always important for an intelligent investor to invest with due diligence and consider all the factors that may influence the price of a stock.