PB Ratio (Price to book ratio)

Let us understand some basic terms we need to know before going through P/B ratio.

What are assets?

Resources that generate cash flow in a short or long-term known as assets. According to investomanthan, assets are referred to as resources that bring money into personal company's account.

What are liabilities ?

Liabilities are resources that you owe to someone or any company. According to investomanthan, liabilities are resources that take money out of your personal or companies account. 

What are tangible assets ?

Tangible assets are assets that have some kind of physical appearance. In simple words, assets that add value and could be touched.

Some examples of tangible assets are : Cash, Land, Stocks, Bonds, Equipments, Machinery, Furniture, Inventory, etc.

What are intangible assets ?

Intangible assets are assets that lack physical appearance. In simple words, such assets that are of great value but cannot be touched.

Some examples of intangible assets are : Patents, Costumer list, Good will, Copyright, Brands and Trademarks, Franchise agreements, Trained Work Staff,etc.

What does liquidation means ?

 Liquidation refers to selling off all the company's assets and paying off all its liabilities or debts. Simply assets minus liabilities or company's income minus expenses.

Before going to p/b ratio let's first understand only denominator part of p/b ratio i.e. b (book value).

What is book value ?

Book value is a economic term which means the value of a company according to books (accounts).

-) Book value of a company is its net worth or shareholders equity in the firm.

-) Book value is the amount that investors and share holders receive when a company is liquidated.

-) Book value is the fund or value remained after selling off all the assets and paying of all its liabilities.

CALCULATION OF BOOK VALUE

Book value is calculated by basic formula :

Total Assets - Total Liabilities

More precisely it can be stated as :

Total Assets - (Intangible Assets + Total Liabilities)

WHAT IS P/B RATIO ?

P/B ratio is also known as Price to Book ratio. It is a financial ratio that compares companies market price over its book value. This ratio determines the amount that an investor will receive if the company seizes its operations and sells off its assets to pays all liabilities. 

P/B RATIO FORMULA

There are two methods to calculate P/B ratio :

-) First method to measure PB ratio, is to divide company's market cap to its book value.

PB ratio = Market capitalization ÷ book value

Let us consider a manufacturing company A with a market cap of $5 million dollars. Company has land, its stock, mutual funds, machinery $50k cash and debt of $3 million. Hence, book value according to balance sheet is $4 million. PB ratio that comes out to be 1.25.

-) Second method is more practical and can be calculated by dividing company's current share price to book value per share. Second method is more commonly used to calculate this ratio.

PB ratio = Share price ÷ Book value per share

Let us take a realistic example of Raymond industries which is currently trading at Rs 223 per share. If we consider consolidated results, book value per share comes out to be Rs 306. Hence, PB ratio comes out to be 0.72. If all the fundamentals are properly analyzed then it seems to be a very solid investment.

If you use moneycontrol.com, go to website and type Raymond in the search box. Scroll down the page to statistics section where you will find PB ratio. Book value per share is given below PB ratio.

Note : Do not make any investment decision based upon any one parameter of fundamental analysis !

Daniel : Hey Investomanthan, where do I find book value and could you please suggest how can I monitor book value of any company ?

Investomanthan : It is a difficulty that many investors face while investing. The site they refer might not include all financial ratios. This problem can be sorted out by referring to moneycontrol.com. Type the company's name in search box, slide the menu bar, and you will find financials. Click on financials and then balance sheet. The first part in the balance sheet you will find shareholders funds. The shareholders fund is the book value of a company. Divide shareholders fund by total number of outstanding shares you will get book value per share.

UNDERSTANDING P/B RATIO

There is no PB ratio high or low. Investors often look for PB ratio under 1.

Why PB ratio under 1 ?

PB ratio under 1 means company's asset value is more than its market value. If the company is liquidated with immediate effect, the value that each investor will receive.

Let us make it simpler. A company XYZ is trading at $1.9 each share and book value per share $3 hence P/B ratio is 0.64. This PB says that for $1 of company's asset, investors are paying only 64 cents. If the company is liquidated with immediate effect, an investor would receive on an average $1 per share.

Let us take an example of the above company. According to price book value the company seems amazing. Let us take some insights from balance sheet.

This shows decrease in book value/equity (shareholder's funds) of past 1 year. On analyzing the balance sheet of past five years, profit of this company is decreasing Y-o-Y at a fast rate.

This leads to a conclusion that PB ratio less than 1 is not always good. Its indication maybe towards negative growth of company.

-) PB ratio under 1 is a rare case and investors need to investigate the real reason for PB ratio being so low.

-) IT sector companies often have very high PB ratio because IT sector companies are operated on low book value (they have less tangible assets and more of intangible assets).

Why inventors are ready to pay for companies with high PB ratio ?

-) According to accounts, intangible assets do not play any role in growth of the company. As we discussed in drawbacks, PB ratio neglects intangible asset. Since we know that trained manpower, copyrights, brands, trademarks, patents, leadership, strategy, etc all these assets contribute great amount in growth of company. Therefore, people buy company with high PB.

-) Other reasons might be any great perception on future earning or profits of the company.

ADVANTAGES OF USING P/B RATIO

-) PB ratio compares the market value with the book value. Book value is considered as the real worth of company.

Price to book value of Reliance Industries is 1.88. This 1.88 suggest that investors are ready to pay 0.88 times more than the asset value of the company.

As we saw Raymond above, it has PB ratio of 0.78. It means that investors are paying less as compared to assets value of Raymond.

-) PB ratio analysis is better with asset heavy industries.

Companies with large value of assets are known as Asset Heavy Industries. Oil, Mining, shipbuilding, Manufacturing, automotive, etc are some examples of asset heavy industries.

DISADVANTAGES OF USING P/B RATIO

-) Every company has its own accounting policies and methods. Different company may use different accounting policies and methods. This makes difficult for investors to evaluate one parameter on two different policies or methods.

-) Technological advancement and factors like inflation have a great impact on market price and book value. Such factors are not included in price to book ratio.

-) This ratio might be difficult in evaluating low asset industries like IT sector companies.

Companies with small value of assets are known as low asset industries. IT sector companies generally get a rented office or they carry out their operations in a co-working space. Asset with such companies maybe only the laptops that are used in carrying out day-to-day operations.

-) Intangible assets have nothing to do with price to book ratio.

It is said that customers are big assets in business. No customers no business. Hence, customers generates cash flow. PB ratio does not take into consideration any of the intangible assets.

INVESTOMANTHAN'S ADVICE

CORRECT WAY TO MEASURE PB RATIO

-) Before analyzing PB ratio, investor must understand whether company is driven by tangible or intangible assets. You can't compare TCS with Reliance industries because TCS  is more of intangibles and Reliance is tangible driven.

-) Compare PB ratio with companies of same sector.The above comparison can't be accomplished because both company belong to different sectors.