FINANCIAL TOOL
Price-to-Book Ratio
Here’s one method of finding potentially undervalued companies.
It’s relatively simple: the price-to-book (P/B) ratio.
What is the book value? It’s what the company is likely to be liquidated for if it were simply sold for the value of its physical assets.
Book Value = Total Assets – Intangible Assets – Total Liabilities
This assumes no value for any future earnings, goodwill or other potential profit-making characteristics of the business. It’s a very conservative valuation of its lowest sell price assuming it went bust.
What is the price?
Price = Current Stock Price x Number of Shares Outstanding
By dividing Price by Book Value, we can determine how much added value is attributed to the business due to its intangible assets. Intangible assets are essentially the speculative part of the valuation, how much investors are estimating that future earning potential to be worth.
Some deep value investors would consider a ratio close to, or even below, 1 to be a high-probability bet on upward price movement.
Why?
Because if a company’s price is below the book value that it could be sold for, then it appears investors are already betting on its failure.
In other words, investors are willing to pay less today than it will be worth when liquidated so that they get a reasonable return on investment even if the company goes under.
Any success at all from the company would likely cause its price to increase, though of course there are no guarantees. It’s just a higher probability trade.
But betting on failing companies isn’t a high-return strategy in the big picture. So many value investors prefer a P/B ratio at 3 or below.
There are limitations:
If the book value goes negative due to more intangible assets or liabilities (which could especially happen for things like tech or service companies), then the ratio becomes meaningless.
In a high-growth company, the P/B ratio could be much higher and yet still have plenty of room for price growth.
As with all things finance, there is no one-size-fits-all method. But the P/B ratio is one tool you can use to understand the current state of a company’s price in comparison with peers in its same industry.