A price-to-book ratio is a measure of value used by financial analysts and investors. It represents the market value of equity in relation to the book value of the equity, and gives an idea whether an investor is paying too much for what would be left if the company went immediately bankrupt. While a price-to-book ratio does not indicate anything about the ability of a firm to generate shareholder profit, it usually serves to indicate whether a stock is overvalued or undervalued.
As with most ratios, the definition of what is a good price-to-book varies by industry. Companies requiring more infrastructure capital, such as a manufacturing company, tend to trade at lower price-to-book ratios than firms requiring less capital, such as a consulting firm. A higher price-to-book ratio typically indicates that investors expect management to create more value from current assets, or that the market value of a firm's assets is significantly higher than the book value.
There are two common ways to calculate price-to-book ratio. The most common way it is calculated is by dividing the market value of equity by the book value of equity. Alternatively, the firm’s market capitalization can be divided by the total book value included on its balance sheet. Price-to-book ratios can also be determined by calculating the differential between the return on equity and the required rate of return on its projects. Regardless of the method used, the price-to-book ratio will be the same; it is presented as a single numeric value, also called a multiple.
A price-to-book ratio or multiple of less than one would imply that the firm’s stocks are priced less than their book values in the market; in other words, the firm is undervalued. Price-to-book ratios less than one are common in the case of economic inflation or when there is a poor-performing market. When a firm is overvalued, the price-to-book ratio will be higher than one. Historically, when the economy and stock markets are strong, firms have traded above a price-to-book ratio of two, indicative of the potential that stocks below their current book value carry.
There is a strong relationship between price-to-book ratios and returns on equity. Firms that have high returns on equity tend to sell above book value while firms with low returns on equity tend to sell at or below book value. Investors usually should pay careful attention to firms that exhibit mismatches of price-to-book ratios and returns on equity, low price-to-book ratios and high return on equity, or vice versa.
