In the world of finance, there are tons of ways to measure the value or potential of an investment, particularly in the stock market. Seasoned investors often spend ample time fine tuning their approach to investment decision making. Each investor will have a unique opinion on how to make trades based on their experience, goals and risk tolerance. A popular quantitative metric is the price to book value ratio. In this article, we’ll deep dive into what the price to book value ratio is, how to calculate the ratio, and how to assess it. Continue reading to find out more!

What is price to book value ratio?

The price to book value ratio measures the current market value of a company against its value on the books. In other words, this ratio gauges whether a company or investment is undervalued or overvalued. Generally, a price to book value ratio of 1.0 or less communicates that an investment is undervalued. On the contrary, a price to book value ratio over 1.0 communicates that an investment is overvalued.

You might be wondering, isn’t the market value and book value the same? It is not! The price is the current market value of a particular investment. This could be the stock price or recent valuation of a company. Whereas the book value is the amount listed on the balance sheet of the company. Normally, the book value is expressed at cost, not current market value, which is why these two values are rarely the same. 

Traditionally, the price to book value ratio is used to assess a stock’s valuation and its accuracy. However, the same logic can be applied to virtually any investment or company, given that it has a market and book value.

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How to Calculate Price to Book Value Ratio

The price to book value ratio is calculated as the current price divided by the book value of an investment. You can calculate the book value by reviewing the balance sheet of a company. The value is calculated as assets minus liabilities (which is simply equity). Let’s take a look at a quick example below of this calculation. 

Company XYZ reported the following on their balance sheet as of December 31, 2023:

• Assets = $1,000,000
• Liabilities = $600,000
• Outstanding shares = 1 million
• Stock price = $1 per share

The book value, or equity value, is calculated as $400,000 ($1,000,000 – $600,000). The book value per share is calculated as $0.40 ($400,000 / 1 million shares). Finally, the price to book ratio is calculated as 2.5 ($1 / $0.40). In this scenario, Company XYZ is trading stock at two and a half times its book value. 

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What does a low or high price to book value communicate? 

When an investment has a high price to book value ratio, it means the investment is trading at a higher value than what is reported on the books. This is to be expected because investments build equity through their branding, experience, and synergies. 

For instance, you can buy a cup of coffee at a local coffee shop or you can make one at home. But, many people choose to go to Starbucks or Tim Hortons instead. This is because they offer speedy delivery, a uniform experience at all their stores, and a particular taste. As a result, people tend to value the experience at these chains more than it’s actually worth financially. Especially in comparison to a small coffee shop with no branding, or worse, coffee made at home. This demonstrates why companies become worth more than their book value. 

On the other hand, a low price to book value ratio means an investment is trading at a lower value than what is reported on the books. This is what investors are typically looking for when assessing potential investments. Why? Because a low price to book value communicates the investment is undervalued. This means there’s a greater chance of profit when the market realizes the true value of the investment. 

Price to Book Value Ratio Benchmarks

Here’s some benchmarks to consider when utilizing the price to book value ratio:

• Ratio less than 1.0: Communicates the investment is trading at a value below its book value.
• Ratio equal to 1.0: Communicates the investment is trading at a value equal to its book value. 
• Ratio greater than 1.0: Communicates the investment is trading at a value greater than its book value. 
• Ratio equal to 0: Communicates the investment has equal liabilities and assets, or equity is equal to 0.
• Ratio less than 0: Communicates the investment has more liabilities than assets. This communicates an investment may be struggling financially and operationally. 

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Limitations of the Price to Book Value Ratio

The price to book value ratio helps investors determine whether an investment is over- or under-valued. However, it is only one measurement of an investment’s value and potential. Typically, investors should assess all aspects of an investment prior to making a decision, including both qualitative and quantitative metrics. 

For instance, while a low price to book value is good, it can be too low. If it’s below 0, this means the investment has liabilities greater than its assets. This suggests an investment is struggling financially and operationally. For this reason, it’s not often wise to invest. Furthermore, if a company’s price to book value ratio is very close to 0, you might be apprehensive about investing. But if you assess the qualitative aspect of the company, you might find they’re a new start up with low equity as a result of not having substantial time to grow and establish intrinsic value yet. As a result, you decide to invest.

But on the other hand, a company that is overvalued is not necessarily a bad investment. Mega companies like Telsa, Apple and Walmart tend to be overvalued. However, they still appreciate in value, often in the long run, so it’s not to say that you shouldn’t invest.

Ultimately, no investor should rely on any sole ratio or aspect when making decisions. Rather, they should use a variety of metrics to gather a comprehensive picture of the investment’s value. It can take time to fine tune your valuation approach, but that’s a part of the investing journey!

What is a good price to book value ratio?

A good price to book value ratio is typically between 0.5 and 1.0. A ratio in this range communicates that an investment is undervalued, but not in a financial or operational danger zone. By investing now, the market will eventually realize the hidden value and you will win as an investor. Although, what is considered a good price to book value ratio can vary by industry, investment type and risk tolerance. Make sure you consider your investing values and financial goals when fine tuning your valuation approach to investments. Good luck on your investing journey!

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