10 Second Take:
Price-to-book ratio can help indicate if a stock is undervalued.
What it means:
Value investors who like to find quality companies to purchase for the long term will often use this ratio as a method to uncover potentially undervalued investments. A P/B — or price-to-book — ratio measures the difference between what a company is worth on paper (its “book value”), and how much investors are willing to pay for it (that would be its “market value”).
To complete this equation, the first step is to establish book value. This is done by taking all of a company’s assets and subtracting any liabilities. (This is similar to how you might determine your own personal net worth.) Once you have a company’s book value, you can divide that by the number of shares outstanding — which gives you the book value per share (BVPS). On its own, that number doesn’t give you much information. However, when you divide the stock price by the book value per share, you get a ratio that can provide some insight and context to the company’s position. If the ratio is above one, the company is trading at a premium to its book value. In other words, you are paying more for the company than its underlying assets are worth. If the ratio is below one, the company’s market value is less than the value of its underlying assets.
How do you take meaning from this ratio? One way is by comparing the ratios of companies within the same industry. This can be a good way to compare companies with different share prices. In some sectors, a high P/B may be acceptable to investors. Another way to use P/B ratio as an evaluation tool is to rate a company’s P/B compared to previous years. The price-to-book ratio is one of several tools value investors use as a strategy for picking stocks that appear to be trading for less than their book value.