Zacks
5 Value Stocks with Low Price-to-Book Ratio for Big Returns
Zacks Equity Research
Updated

The most popular valuation metrics used to evaluate companies are Price-to-earnings (P/E) and Price-to-Sales (P/S) ratio. However, price-to-book (P/B) ratio is often overlooked by investors. The price-to-book ratio is determined by comparing a stock's market price to its book value.

It is calculated as given below:

P/B ratio = market capitalization/book value of equity.

Defining Book Value

There are several ways by which book value can be defined.  It is the total value that would be left over, according to the company’s balance sheet, if it goes bankrupt immediately. In other words, this is what shareholders would theoretically receive if a company liquidates all its assets after paying off all its liabilities.

It is calculated by subtracting total liabilities from the total assets of a company. In most cases, this would equate to common stockholders’ equity on the balance sheet. However, depending on the company’s balance sheet, intangible assets should also be subtracted from the total assets to determine the book value.

What is P/B Ratio

By comparing book value of equity to its market price, we get an idea of whether a company is under- or overpriced. However, like P/E or P/S ratio, it is always better to compare P/B ratios within industries. 

A P/B ratio less than one means that the stock is trading at less than its book value, or the stock is undervalued and therefore a good buy. Conversely, a stock with a ratio greater than one can be interpreted as being overvalued or relatively expensive.

But there is a caveat. A P/B ratio less than one can also mean that the company is earning weak or even negative returns on its assets, or that the assets are overstated, in which case the stock should be shunned because it may be destroying shareholder value. Conversely, the stock’s share price may be significantly high – thereby pushing the P/B ratio to more than one – in the likely case that it has become a takeover target, a good enough reason to own the stock.

Moreover, the P/B ratio isn't without limitations. It is useful for businesses – like finance, investments, insurance and banking or manufacturing companies – with many liquid/tangible assets on the books. However, it can be misleading for firms with significant R&D expenditures or high-debt companies or service companies or those with negative earnings.

In any case, the ratio is not particularly relevant as a standalone number. One should also analyze other ratios like P/E, P/S, and debt to equity before arriving at a reasonable investment decision.

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