Beginner’s Guide: What is the P/B Ratio in the Stock Market?

The P/B, or Price to Book Value Ratio, compares a company’s book value with its price in the stock market.

Book Value, also called Shareholders’ Equity, is simply a company’s assets minus their liabilities.

Book value is not usually explicitly referred to in a company’s financial statements, but is commonly known as another term for shareholders’ equity, which is referenced in a financial statement (the balance sheet).

The formula for the P/B ratio is the following:

Price to Book Value (P/B)

= Price / Book Value
= Market Capitalization / Shareholders’ Equity
= Market Capitalization / (Total Assets – Total Liabilities)

The reason why we substitute Market Capitalization for Price in Price to Book Value is because both Book Value and Market Capitalization compare the total value for a company, rather than its per-share value.

Price-based relative valuation ratios such as P/B and P/E need to be calculated on an apples-to-apples basis, where the numerator (price) and denominator (book value or earnings) need to both be on a total value or per-share value basis.

To calculate the Price to Book Value (P/B) Ratio on a per-share basis, the formula is:

Price to Book Value (P/B)

= Price Per Share / Book Value Per Share
= Stock Price / Book Value Per Share
= Stock Price / [(Shareholders’ Equity / Shares Outstanding)]

You can see that calculating a company’s Book Value Per Share, or BVPS, allows us to use the company’s stock price in the P/B ratio, rather than having to calculate Market Capitalization (which is Stock Price multiplied by Shares Outstanding).

Price to Book Value Meaning

The P/B is a common ratio referred to in value investing strategies, especially because its usage was first popularized by “the godfather of value investing” Benjamin Graham in his bestselling book The Intelligent Investor.

Ben Graham was famously Warren Buffett’s teacher at Columbia University, and had a huge influence in the early parts of Warren Buffett’s career.

Price to Book Value, like Price to Earnings, is a ratio to tell investors how cheap or expensive a stock is compared to a specific financial metric—in this case Book Value. In general, higher Price to Book Value stocks are considered more expensive, though this can vary greatly depending on a company’s profitability and expected future growth.

Ratios like the P/B are especially useful in allowing investors to compare one company’s price in the stock market to another, regardless of how big or small those companies are.

Since the stock market has such a wide range of sizes, from companies that are $10 million in market capitalization to companies that are over $1 trillion, Price to Book Value is a simple, quick way to compare a company’s valuation (cheapness or expensiveness) relative to another’s.

Price to Book Value Usage in Value Investing

P/B became an extremely popular formula in Buffett’s rise to popularity, because Buffett would frequently credit Ben Graham’s ideas as behind the foundation of his strategy.

Investors who read Graham’s The Intelligent Investor grew really attached to the formulas in the book, such as the Graham number, which used the P/B ratio to assign a value to a stock.

Graham preferred low P/B stocks, especially those trading less than 1, because buying a stock with a Price to Book less than 1 is like getting $1 bills for less than $1. This strategy took on a newer form called “net net investing”, in which investors simply buy companies trading for less than the Net Asset Value, a very similar concept to buying stocks with a P/B less than 1.

Investors really like the P/B ratio because of the simplicity behind it, and its empirical nature.

There is no debate on what a company’s Book Value is, it is right there on the balance sheet. So, there’s also no debate on its P/B, and it can be used in a highly scientific fashion.

Studies came out in the subsequent decades to Graham’s bestseller, such as those by Fama and French and James O’Shaughnessy, which showed backtests where investors could’ve outperformed the market by simply buying many low P/B stocks, selling the portfolio, and then re-buying many low P/B stocks on a frequent basis.

Why Some Companies Have High P/B Ratios

Like I mentioned earlier, a company’s profitability and future growth has a huge bearing on its P/B ratio and can sometimes make using the P/B a poor way to compare valuations, especially if a company is able to earn high returns on its equity (or ROE).

Because Price to Book Value looks at a company’s (shareholders’ equity), it is a formula that is highly influenced by that company’s assets.

And not all assets are created equally.

Some assets create much higher returns than others (are more efficient), and some assets are valued differently on balance sheets because of accounting rules.

1– Differences in Efficiency

Take the difference between a highly capital intensive mining company, and a high margin consumer products company.

For a mining company, most have to buy expensive equipment (long term asset) which allows them to dig holes in the ground on tough terrain. This equipment can be expensive, and if it is just one piece of the mining company’s required investments and expenses, can result in a relatively low level of profits compared to the capital needed.

On the flip side, if a consumer products company becomes very popular with consumers (such as through word of mouth), it may only need a small number of manufacturing plants (long term assets) in order to produce high volumes of its products and thus relatively high levels of profits.

The consumer products company will probably have a higher Return on Equity (ROE) than the mining company if these factors are in place; therefore it is likely to also have a higher Price to Book Value too.

2– Differences in Asset Accounting

Due to accounting rules, assets are required to be recorded at cost on balance sheets. This remains true even if the asset is becoming more valuable over time.

While long term assets like equipment may lose value over time, other long term assets like real estate are likely to increase in value over time, but both will be recorded at cost on the balance sheet and then depreciated over time.

The way that the asset value of brands is calculated can also vary greatly depending on a company’s situation; brands that were acquired through M&A show up as an asset on the balance sheet, while those generated internally do not.

These differences and more can skew a company’s asset values, which skews their book value, which makes a P/B ratio potentially deceiving to the investor.

Why Some Companies Have Low P/B Ratios

Like with the P/E ratio, companies that have lower growth prospects or have matured in their company life cycle will usually trade at lower P/B ratios. They can also trade at lower P/B ratios because they are much less capital efficient (lower ROE’s) than the average.

Investors tend to buy companies with better growth prospects, whether tangible or imagined. So if a company has had a poor growth track record, or a perceived dim future, it will tend to trade lower.

Lower sentiment around a stock will usually reduce its P/B ratio, but the extent of this factor can vary greatly due to the profitability of the company and its industry too.

When you look at a company’s P/B ratio, make sure you are comparing it with its peers in order to get a better picture on whether the low P/B ratio indicates a stock that’s truly a better deal. Keep in mind that even this approach can be flawed too though, especially if an entire industry has fallen out of favor with the market.

The Math Behind Why ROE will Always Affect P/B

Really quickly I want to show the exact relationship between P/B and ROE, because when I learned this myself it really explained to me why high ROE usually means high P/B.

Say we have two companies trading at a Price to Earnings (P/E) ratio of 20.

Let’s say that both companies are trading at $100, which means their earnings are $5.00 per share ($100 divided by 20 is equal to $5). Now let’s say that company A has a Return on Equity of 40% while company B has a Return on Equity of 10%.

Recall that Return on Equity is simply Earnings divided by Shareholders’ Equity. This means that the Equity for company A must be $12.50 per share ($5 / $12.50 = 40% ROE). Similarly, company B must have Equity of $50 per share ($5 / $50 = 10% ROE).

Now, what must be the P/B ratios for the two companies?

  • Company A
    • P/E = 20
    • Stock price = $100
    • Earnings Per Share = $5
    • Return on Equity = 40%
    • Shareholders’ Equity per Share = $12.50
  • Company B
    • P/E = 20
    • Stock price = $100
    • Earnings Per Share = $5
    • Return on Equity = 10%
    • Shareholders’ Equity per Share = $50

We already have the pieces we need to calculate Price to Book Value. Simply take the Stock Price and divide it by the Shareholders’ Equity per Share, aka Book Value per Share.

  • Company A
    • Stock price = $100
    • Shareholders’ Equity per Share = $12.50
    • P/B ratio = 8
  • Company B
    • Stock price = $100
    • Shareholders’ Equity per Share = $50
    • P/B ratio = 2

Do you see how two companies with the same amount of earnings will have two very different Price to Book Value ratios simply because their Return on Equity values are so different?

Notice how the P/B ratio is 4x higher for company A, as is their ROE.

This is why companies that are more capital efficient, earning higher returns on their capital (equity) will trade at higher P/B ratios in the market. Not only because Wall Street tends to like higher ROE companies more, but also because the math literally requires it.

Be careful of being too over reliant on using the P/B ratio to try and pick cheap stocks, as using it blindly will literally force you into the less capital efficient companies…

Who will have a harder time compounding because they need more capital to grow.

Best Times to Use P/B Formula for Value Investing

That said, certain companies are perfect for using Price to Book Value on, also because of their business models.

1– Banks

Banks are the poster child for using P/B to value them, specifically because they derive their profits directly from book value. Regulators require banks to hold a certain amount of equity in reserves before they can make loans to generate profit.

Because banks have been out of favor since the ‘08/’09 financial crisis, they have traded at lower P/B ratios compared to the rest of the market in the 2010’s, and so they have drawn more attention from value investors lately.

P/B is likely to continue to be a great way to value a bank because of the balance sheet (instead of cash flow statement) focused nature of their business.

2– Super Cyclicals

Companies with highly volatile cash flows and returns on capital— such as companies that are extremely cyclical—are also great to value with Price to Book Value rather than P/E or P/FCF.

Because these companies earnings will swing so much due to the boom and bust nature of their industry, using an earnings or cash flows focused valuation metric is usually not a great way to go because those booming cash flows are likely temporary and don’t reflect long term value.

Assets and book value tend to be much less variable to change from year-to-year especially with super cyclicals, and so are more likely to better reflect the actual long term earnings power and value of that business.

Examples of super cyclicals where you might think about using P/B as a valuation metric:

  • Homebuilders
  • Commodity companies
    • Steel
    • Aluminum
    • Plastics
    • Lumber
    • Mining
    • Oil & Gas
  • Semiconductors

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