The Price-to-Book ratio explained.

The price-to-book ratio is a “valuation metric” that measures the current market value of a company relative to its book value (also known as shareholders equity). The book value represents all the physical capital a company invests in, such as warehouses, computers, machinery, property, and inventory. The price-to-book (P/B) ratio is important because it helps investors understand whether a company’s market price seems reasonable compared to its balance sheet.

Book value is the amount that would remain if a company liquidated all its assets and repaid all its liabilities. It is useful when applied to companies with a significant amount of assets on their books.

The P/B ratio is very industry-sensitive, with heavy asset-backed businesses like manufacturing having lower ratios than say a SaaS company. It does not consider other assets that can make up the value of a company such as intangible assets like brand names, customer goodwill, and patents, which aren’t reflected on the balance sheet. Physical asset-heavy businesses like banks and real estate investment companies cannot be compared to technology businesses with minimal physical assets.

I use the P/B ratio for businesses that need their physical assets to derive earnings and cash flow. Understanding the value of such businesses based on their physical revenue-generating assets is crucial to avoid overpaying. For instance, a manufacturer needs warehouses, machinery, and a heavy demand for those components to earn revenue. This is different from a cloud business selling an online subscription model that requires people, IP, and a different “asset” base to generate revenue.

Modern companies’ market value often exceeds their book value due to evolving business models and markets. The P/B ratio, once a great tool for value investing, is not as effective when valuing new-age businesses.

What is the Price-to-Book formula?

• P/B = Market Price Per Share ÷ Book Value Per Share
• Book Value = Found on the balance sheet and is the Total Assets minus the Total Liabilities.
• The ratio can be done on a per-share basis or as a whole. The Market cap is divided by the Book Value of equity.

P/B can include or exclude intangible assets and goodwill. If excluded, it’s called “price to tangible book value” or “price to tangible book”.

How to use the P/B ratio?

The industry typically views a P/B ratio of 1 as the stock price aligning with the company’s book value. Ratios below 1 are considered solid investments, while ratios above 1 indicate a premium.

In this example below let us compare two companies in the same manufacturing industry that depend on their physical assets to generate revenue. An industry benchmark is important as it gives us a guide as to whether a company is over or under valued against its peers. Let us assume the industry benchmark has a P/B multiple of x2.

P/B Ratio	Company A	Company B
Share Price	$5.50	$4.35
Shares Outstanding	125 million	71 million
Market Cap	$687 million	$308 million
Assets	$240 million	$178 million
Liabilities	$125 million	$28 million
Book Value of Equity	$115 million	$150 million
Book Value Per-Share	$0.92	$2.11
Price-to-Book:	5.97	2.06

Company A $687m ÷ $115m = 5.97

Company B $308m ÷ $150m = 2.06

Company A with a P/B of 5.97 would be interpreted as its market value being roughly 5.97 times the net worth of its physical assets such as warehouses, machinery, trucks, inventory and parts yet to be used to create its product. All the P/B ratio tells investors is how much value the market places on each dollar of a company’s net worth. If the industry benchmark is 2 then Company B would be fair value to the industry while Company A may be considered overvalued.

The higher P/B ratio implies that investors expect the company to create more value from its assets. A lower ratio may indicate the company has a market cap lower than its book value of equity, meaning the market does not believe the company is worth the value on its balance sheet. When peer comparison is being done it is important to also look at a company that may have a big goodwill allocation sitting on the balance sheet, consider removing this from the Net Book Value to create a better picture.

In Summary…

The P/B is best used when valuing capital-intensive industries like manufacturing, banks, insurance companies, real estate businesses, transport, and airline companies. Debt is another area to be mindful of, the P/B does not consider companies with high P/B multiples due to large debt levels wiping out the book value.

P/B ratios do not directly provide much insight into the ability of the business to generate profits or cash for shareholders. P/B is best used directly with the return on equity ratio because it shows how much profit is being generated with the company’s assets. Used together it can help separate overvalued companies from those with enough promise to support the higher share price.

One important note, if there is a big difference between price-to-book and return-on-equity, it is likely due to being overvalued. A business generating strong returns will also show growth in the P/B ratio.

A high P/B ratio could be due to a company operating in an industry that relies on human capital or has a high return on assets. 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 and this can cause the P/B to be quite high.

Is a high or low P/B ratio better? Like everything it all depends on what you are looking for and your style of investment. Value investors look for lower P/B ratios as it gives them a greater margin of safety while waiting for the market to catch up to the true value of the company. Most growth-focused investors I know don’t even use this ratio at all!