Aug 18 2009

Using Price\Book Ratio

The price to book value (P/B), or price book ratio, is one of a number of relative valuation tools that are used as quick and easy shortcuts to analyse and screen stocks.

‘Relative’ in this context means relative to the stock price or to stock market prices at this point in time.

I use the term absolute valuation to refer to procedures that calculate the fair value of stocks using company data such as the methodogy described by McNivan.

The stock price is not used in the McNivan calculation, which is why I refer to it as an absolute valuation term.

Calculating the P/B Value
The P/B valueis calculated by dividing the current closing price of the stock by the latest reported book value per share (see below). It is also known as the price-equity ratio.

The price to book value is calculated as …

P/B ratio = Stock price/ Book value per share

In some countries the P/B value is known as the net asset value (NAV) of a company or net tangible assets (NTA).

Benjamin Graham suggested that reasonably priced US stocks could be identified by multiplying the P/E ratio by the P/B ratio.

If the resulting number was below 22.5 then the stock represented reasonable value.

Shareholders Equity or Book Value
Shareholders equity is the capital invested from shareholders and from retained profits (i.e., not distributed as dividends). It is measured by adding share capital, reserves, retained profits and minority interest. It is equivalent to the book value (of equity).

The book value represents the total value of the company’s assets that shareholders would theoretically receive if a company were liquidated. And by being compared to the company’s market price, the book value can indicate whether a stock is under- or over-priced.

Book Value Concerns
Book values are only as good as the numbers used to produce them. The challenge is to work out if the numbers are realistic. Also, keep in mind that book values look backwards whereas the share price looks forward. A lower price to book value could mean that the stock is undervalued. However, it could also mean that there could be a problem with the company.

To Conclude
As with most ratios, the average P/B value may vary from industry to industry. But it does provide some idea as to whether you’re paying too much for what would be left if the company went bankrupt immediately.

There are other ratios that belong in this relative valuation set that includes the P/B value and the P/E ratio, but the question is – how many do you need!

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