The role of the price-to-book ratio in fundamental analysis
It’s just a data point, but when used in the right context, it can be very revealing.
What is the price-to-book ratio?
The Price-to-Book (P/B) ratio is a financial ratio that compares a company’s book value to its current market value. The P/E ratio identifies the share of a company that is owned by its shareholders.
The formula for the P/B ratio is:
Market capitalization/current book value of equity
Company market capitalization is usually readily available. However, it can be calculated by multiplying the current share price by the number of diluted shares outstanding. A company’s book value (value of tangible net assets) is the company’s assets minus its total liabilities which may include intangible assets (eg patents, goodwill). This is taken from a company’s financial statements which most companies publish quarterly.
What is the purpose of the price-to-book ratio?
The P/E ratio (less known as the price-to-equity ratio) is just one of many metrics value investors can use to make an investment decision. The specific purpose of the P/B ratio is to give an idea of the company’s valuation.
Even more specifically, the P/E ratio attempts to answer the question, “Am I paying too much for what would be left of this company if it went bankrupt?” If a company goes bankrupt, it will have to liquidate all of its assets and repay its debt. Whatever the remaining value would be the book value of the business. In this context, the P/E ratio allows investors to see if they are getting growth at a reasonable price.
In general, a stock with a low P/B ratio (around 1) suggests that the stock is undervalued. However, there are many other things to consider. For example, if a company is in an emerging industry, its price-to-book ratio will likely be much higher. And for low-growth companies, such as utilities, too low a P/E ratio could suggest that the company has other financial problems.
Is the price-to-book ratio a standalone indicator?
The P/E ratio is just one data point that value investors can use. It is often compared to a company’s return on equity (ROE), which is a reliable indicator of growth. Ideally, value investors are looking for these two numbers to show a decent correlation. In other words, if a company’s return on equity increases, its P/E ratio should increase. When a company has a low ROE and a high P/B ratio, it’s almost always a sign that a stock is overvalued.
What is a good price-to-book ratio?
As stated above, in general, a “good” P/B ratio is considered to be less than 1.0. This is universally considered a sign that a stock is undervalued. Benjamin Graham, considered the “father of value investing”, believed that value investors should not invest in stocks with a P/E ratio greater than 1.5. It’s safe to say that today’s stock market is very different from what Graham experienced. And today, many investors consider anything below 3.0 to be a good price-to-book ratio.
However, an important concept to remember about the Price-to-Book ratio is that the proper analysis of what makes a good or bad P/B ratio may depend on the industry or sector. For example, let’s look at the P/E ratios for two companies in the semiconductor industry: Advanced Micro Devices (NASDAQ: AMD) and Intel (NASDAQ: INTC).
As of this writing, AMD registers with a P/B ratio of 20.11. This is much higher than the industry average of 3.58. INTC has a P/E ratio of just 1.95. Although this is a little higher than some analysts would like, it is well below the P/E ratio of an industry competitor. It is also lower than the industry average.
At first glance, this would make Intel the better option. And the reality is that it will be a better option for value investors. Intel is a mature company which is reflected in the fact that it pays a dividend. However, growth investors are much more likely to choose AMD, which is a company still in growth mode. With this in mind, growth investors are more likely to ignore the P/B ratio altogether.
What are the advantages of the price/book ratio?
Compared to other valuation measures, the P/B ratio has several advantages. First, a company’s book value is usually positive even if the price-to-earnings (P/E) ratio is negative, meaning the company is not profitable. In cases like these, the P/B ratio can be used as a sort of proxy. Second, a company’s P/E ratio tends to be less volatile than the P/E ratio.
What are the downsides of the price to book ratio?
The P/B ratio should be considered in context. By itself, a low P/B ratio does not mean that a stock is undervalued. In fact, it can suggest that a business is in financial trouble. Conversely, a high P/E ratio does not necessarily mean a stock is a bad choice for value investors, as it reflects a moment in time.
The P/B ratio only covers tangible assets. However, businesses have intangible assets that should rightly be taken into account in assessing the value of a business. For example, companies such as Starbucks (NASDAQ:SBUX) and Amazon (NASDAQ:AMZN) have a high brand value that is not taken into account. In addition, the P/B ratio does not correctly value the human capital found in many service companies.
At first glance, the P/E ratio does not take into account the different production methods that can change the value of assets. Likewise, inflation and technology can have a significant effect on the book and market value of assets. Additionally, investors should be aware of which accounting method is used (GAAP, non-GAAP, IFRS) as this will result in different asset values.
Some final thoughts on the price-to-book ratio
When investing, investors should hope for the best but plan for the worst. The P/B ratio is a measure that shows the relationship between a company’s market capitalization and its book value. A company’s market capitalization defines the price that investors believe the company’s equity is worth. Book value is the value of assets that shareholders would get if the company went bankrupt.
Because the value that investors place on equity can be different from book value, the P/E ratio provides value investors with a reality check. For this same reason, growth investors generally don’t place much importance on the P/E ratio, as companies that show strong growth will often have a high P/E ratio.
7 stocks of electric vehicles ready to charge higher
The Biden administration has announced a framework for a leaner $1.5 trillion infrastructure bill. Part of that framework will be a $12,500 tax credit for electric vehicle purchases. This increases the current grant by $4,500. And that’s music to the ears of electric vehicle companies in the United States that are considering ramping up production.
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Check out the “7 Electric Vehicle Ready-to-Charge Stocks Above”.