When it comes to the fundamental analysis of stocks, investors use many financial ratios to determine whether a stock is undervalued or overvalued. One among these ratios is the PB ratio. Unlike a few others, computing the PB ratio is very easy and along with the PE ratio should give you an accurate picture of where the company stands in terms of investment worthiness.
If you’re interested in getting to know what it is and the significance of the PB ratio in the share market, here’s a comprehensive guide that may be able to help.
Let’s start with the basics. The PB ratio, also known as the Price-to-Book ratio is a financial metric used to measure the price of a stock relative to its book value. Investors widely use this ratio to ascertain whether a stock is undervalued (trading below its book value) or overvalued (trading above its book value).
Investors prefer to invest in undervalued stocks since they have a greater chance of appreciating in the future whereas they tend to stay away from overvalued stocks since they have a higher chance of going through price correction in the future.
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Now that you’ve understood the meaning of the PB ratio, let’s take a look at the mathematical formula used to calculate it.
PB Ratio = Current Market Price Per Share ÷ Present Book Value Per Share
Here, the book value per share is arrived at through the use of a simple formula.
Book Value Per Share = (Total Assets - Intangible Assets - Total Liabilities) ÷ Number of Outstanding Shares
Let’s take up an example to properly understand how the PB ratio is calculated.
Assume that you wish to calculate the PB ratio of a listed company XYZ Limited. The current share price of the company is Rs. 3,850 per share.
The company’s total assets are Rs. 1,100 crores, out of which intangible assets account for around Rs. 180 crores. The total liabilities of the company are Rs. 470 crores and the total number of outstanding shares are 14 lakhs.
Substituting the above values in the book value per share formula, we get -
Book Value Per Share = (Rs. 1,100 crores - Rs. 180 crores - Rs. 470 crores) ÷ 14,00,000
Book Value Per Share = Rs. 450,00,00,000 ÷ 14,00,000
Book Value Per Share = Rs. 3,214
Now that we’ve arrived at the book value per share, let’s apply the PB ratio formula.
PB Ratio = Rs. 3,850 ÷ Rs. 3214 = 1.18
Usually, the market value of any particular stock will almost always be higher than its book value. In such cases, the PB Ratio would be more than 1. While having a PB ratio of more than 1 does signify that the stock is overvalued by the market compared to the value in its books, it is not always considered to be a bad sign. As long as the PB ratio is not unnaturally high like more than 2 or 3, a company may still be a good investment even though it is slightly overvalued.
On the other hand, if the market value of a particular stock is lower than its book value, it would have a PB ratio of less than 1. This signifies that the stock is undervalued. Although this is rare, it is not impossible. And stocks with a PB ratio of less than 1 are often preferred by investors and are considered to be solid investments.
That said, when evaluating stocks, you shouldn’t just stop with the PB ratio of a stock. Instead, you should compare it with that of the company’s rivals and the industry average to get a proper perspective.
For instance, you might find a company to be overvalued if you just take a look at its PB ratio and may skip investing in it due to this. However, compared to the industry average and its peers, the company may have a better PB ratio, making it a more attractive investment option even though it is overvalued.
Hope you now know what the PB ratio is. The ratio is a great way to quickly find out if a stock is undervalued or overvalued. However, investors often read the PB ratio along with Return on Equity (ROE). Any large discrepancies between these two ratios are often viewed as a red flag. For instance, a low ROE and a very high PB represent significantly overvalued stocks. These stocks will undergo price corrections and may not be suitable wealth creators.