The price to book ratio or P/B ratio is a metric that reflects how the market price reflects the current book value of the business shares. The Price to Book ratio measures the number of times the market price of the company’s shares exceeds the book value of the business.
What is the Price to Book Ratio?
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The Price to Book ratio is a popular metric that estimates the relationship between the market price of a business’ shares and the actual value of such shares. The book value of a share is derived from the company’s Balance Sheet, by dividing the total shareholder’s equity by the number of shares outstanding. The result is the Book Value of each share. This value can be understood as the value of each share based on the historical value of the company’s assets.
In the event of a liquidation, a company’s book value is a fairly close estimation of its liquidation value, even though many of the items in the Balance Sheet may end up being sold at higher or lower prices than their current value in the books.
Comparing the price of the shares with their current book value gives investors a closer look into how the market is assessing the value of the firm. A high Price to Book ratio means that the market is appraising future business results optimistically, as the value they are establishing for the business exceeds the book value of its equity.
Price to Book Ratio Formula
The Price to Book (P/B) Ratio formula is the following:
P/B = Price of the shares / Book Value of each share
Price to Book Ratio Equation Components
Price of the shares: The current market price of the business common shares.
Book Value of each share: The company’s total assets minus its total liabilities dividend by the number of outstanding shares.
The Price to Book ratio is expressed in number of times the price exceeds the book value of the firm’s shares.
P/B Ratio Calculation Example
Moving Partners is a company that provides moving services for homeowners and tenants. The company owns a large fleet of small and big trucks that they lease people with the proper driver license, or they can also hire a driver to drive the truck for them.
The business is publicly traded, and here’s its latest financial information reported on its Balance Sheet:
Current Assets: $35,600,000
Fixed Assets: $78,940,000
Other Assets: $12,000,000
Total Assets: $126,540,000
Current Liabilities: $24,560,000
Long-Term Liabilities: $56,000,000
Total Liabilities: 80,560,000
Total Shareholder’s Equity: $45,980,000
Additionally, the business has 12,454,000 shares outstanding and the current price of this shares is $12. The book value of each share can be easily estimated by dividing the Total Shareholder’s Equity ($45,980,000) by the number of shares outstanding. As a result, the Book Value of each share is $3.69. With this information we can calculate the Price to Book ratio for Moving Partners, as follows:
P/B = $12 / $3.69 = 3.25
This means that the market is valuing Moving Partners at 3 times the historical value of its assets minus the face value of its total liabilities. While this may seem high, it says the market has an optimistic view on the business, as it is expecting the future cash flows the business will generate to bring a value much higher than its current book value.
Price to Book Ratio Analysis
While the Price to Book is not considered a relevant metric to make a decision on whether to invest or not in a business, it is a ratio that most investors take into consideration, as it provides a picture of how optimistic the market is about the future growth of the business. In other words, the higher the Price to Book ratio, the more the market is relying on the future cash flow streams as the value drivers and not so much on the book value of the firm’s assets.
On the other hand, from the perspective of someone who is in the business of liquidating companies, a book value below 1 indicates that the market is valuing the firm at even less than the book value of its equity, which means the assets are being valued at less their current accounting value. This may indicate that an opportunity to take a profit is at hand, if the liquidator is able to sell the assets at a price higher than their current book value.
While the book value may be a valid reference of the firm’s potential liquidation value, there are several factors that will end up affecting the final amount of money that can be obtained if the firm is liquidated. This difference is usually negative, which means the book value is hardly an accurate figure of a company’s liquidation value. For this reason, the book value is just a referential figure and not a set-in-stone value, as opposed to the market value of the shares, which is the amount that an investor will effectively receive if he sells his shares at that exact moment.
Commonly, during the process of liquidating a business, the value of receivables tend to diminish as not all of the pending invoices are effectively collected, and also, the inventory is usually sold at a markdown of its original cost to liquidate all of it.
Price to Book Ratio Uses, Cautions, Pitfalls
The most relevant aspect of the Price to Book ratio is determining the actual book value of the company’s assets. In almost all cases, the book value is understood as the historical cost of the assets minus its accumulated depreciation. Yet, the market value of such assets may be significantly different than the book value, which will eventually make the book value an irrelevant and potentially inaccurate figure.
Even though that may be the case, the book value does not cover for this difference, as it merely tracks the historical value. In this situation, a business can order an appraisal on all of its assets in order to reassess their value. As a result, the assets may appreciate in value and that difference will increase the book value in a way that will not fall outside the boundaries of the metric.