Is a Higher Price to Book Ratio Better? Book value and market value can be two entirely different figures, whether you are talking about a car, a building, or a Fortune 500 company.
The book value is the amount originally paid for a given asset, reduced by any relevant depreciation.
Market value, on the other hand, is how much those same assets are worth in the eyes of potential buyers. To put it another way, market value is the price an asset will command if sold on the open market.
The relationship between a company’s book value and market value can offer critical insight for investors. In particular, it helps to clarify how much of a company’s value is tangible.
Low price-to-book ratios can indicate an undervalued company – or a company in trouble. High price-to-book ratios might mean share prices rely heavily on intangible assets and consumer sentiment, or they could be a sign of confidence in the company’s growth prospects.
For years, Amazon (AMZN) famously traded with a sky high price-to-book value.
Understanding the price-to-book ratio is an important step in ensuring smart investment decisions. When is a low price-to-book ratio a good buy? When is a higher price-to-book ratio better?
What is Price to Book Ratio?
There are two components to the price-to-book ratio. The first is “price” or the total market value of all outstanding shares of stock in dollars. This figure is also known as market capitalization or market cap. There is no need to calculate this figure on your own, as it is included in any basic summary of a company’s current stock performance.
Essentially, the number of outstanding shares is multiplied by the current price of a single share to arrive at the market cap or “price”, and it represents how much investors believe the company is worth.
In other words, there is some amount of subjectivity to market cap, as it depends on the market’s perception of the organization’s prospects for increasing in value.
The second component of the price-to-book ratio is “book” or book value per share. This is an objective figure that is calculated using hard numbers from the company’s balance sheet. When all assets are totaled, then all liabilities are subtracted, what remains is the book value.
That book value represents what would be left for shareholders if the company were to liquidate. When divided by the number of outstanding shares, the outcome is book value per share.
Book value and book value per share are important considerations for investors who wish to minimize risk. When the book value is low or has gone negative, the company owes more than it is worth. Compare that to being “underwater” on a mortgage, or owing more on the home than the property is worth.
High P/B Vs Low P/B Stocks: What’s the Difference?
The formula for price-to-book ratio is a simple one: current share price/book value per share.
For investors, the book value is a measure of where the company is now, while the market value reflects growth expectations.
Generally speaking, when a company is in good shape, market value should exceed book value. That’s because in most cases, book value doesn’t include a long list of intangible assets such as goodwill, patents, and brand awareness, all of which make a company more valuable.
When the market value and book value are the same – a ratio of 1 – or the price-to-book ratio falls below one, investors in search of undervalued stocks start to get excited. On the other hand, when price-to-book values go too high, many become concerned that the company is overvalued.
However, price-to-book ratios aren’t meant to be considered in a vacuum, and a low price-to-book ratio isn’t always good news for investors. A company in distress will also have a low price-to-book ratio, as assets are depleted and liabilities increase.
The same applies to companies with high price-to-book ratios – sometimes, they are indeed overvalued. It’s also possible that the company owns substantial intangible assets that promise exponential growth in coming months.
When a company like Berkshire Hathaway (BRK.B) trades below book value, it’s often a sign that it is trading at a discount – as was the case following the global pandemic crash.
What Does Low Price-to-Book Ratio Mean?
If you are looking for undervalued stocks, you can start with the price-to-book ratio. Keep in mind that the distinction between low, on-par, and high ratios can differ between industries, and the price-to-book ratio is more useful in some industries over others.
For example, when companies rely on tangible assets to do business, such as manufacturing or transportation, a low price-to-book ratio carries significance.
Price-to-book ratios for companies that generate value through intellectual property – that is, property that doesn’t show on the balance sheet – can’t be compared to asset-heavy peers for the purpose of making investment decisions.
Once you are satisfied that the price-to-book ratio is low compared to the industry standard, dive into financials to validate that the company is undervalued rather than financially stressed. Are asset values being overstated?
If so, the inevitable correction could lead to losses for investors. Is the company’s return on assets low? If so, this can create a low price-to-book ratio that isn’t reflective of undervalued stock.
What Does a Higher Price to Book Ratio Mean?
High price-to-book ratios might be bad news for investors, as they can signify a stock is overvalued.
The market is excited about the company’s prospects, driving share prices up more quickly than projected growth supports. However, high price-to-book ratios aren’t always a result of overvalued stock.
In some cases, the company is generating strong returns on assets, or it owns valuable intellectual property that doesn’t show up on the balance sheet.
A comparison of the return-on-equity ratio can help to separate overvalued companies from those with enough promise to support high share prices.
Specifically, if there is a substantial difference between price-to-book and return-on-equity, it is likely due to overvaluing. Companies generating strong returns will also show growth in the price-to-book ratio.
Is Higher Price to Book Ratio Better? The Bottom Line
Generally speaking, a higher price-to-book ratio can’t be classified as “better” than a low price-to-book ratio. These figures are relative based on the industry and the mix of intangible assets and growth prospects unique to each company.
Value investors tend to be on the lookout for stocks with low price-to-book ratios, as these are more likely than high price-to-book ratio stocks to generate returns when the market eventually catches up to the company’s true value.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.