The Price-To-Book Ratio is a Top Tool To Evaluate Companies
Growth investors increasingly make use of this metric to identify the best stocks to invest in.
The book value of equity is defined as the value of company's assets as shown on the balance sheet. It is the difference between the book value of assets and the book value of liabilities.
Let us look at an example. If company XYZ has $300 million in assets and $100 million in liabilities, then the book value for this particular company would be $200 million. If there are 20 million shares outstanding, then each share would represent $10 of book value. If the market price for a share is currently $25, then the P/B ratio would be 2.5 (25/10).
Be wary of companies that are trading for less than their book value. Also, investors should steer away from stocks with a P/B less than one. It signifies that the asset value is overstated and the firm is earning a dismal return on its assets.
The best companies are those that have a high stock price relative to their book value. They are earning a high return on their assets. When looking at P/B, pay close attention to the ROE as well. A low ROE in comparison to the P/B can be problematic.
Book values tend to get distorted. Share buybacks have an effect on the P/B as the capital gets reduced on the balance sheet. In addition, the book value plunges when cash is made use of to fund a capital expenditure for instance.
In the end, the P/B ratio offers a reality check for an investor and a valuable one at that. The issue with P/B is that it ignores intangible assets like brand value, intellectual property, goodwill and patents. Companies like Microsoft are renowned for their significant intellectual property in comparison to physical property and this ratio does not capture that aspect.