The price-to-book ratio measures the market value of a company relative to its book value and indicates whether a stock is overvalued or undervalued. The ratio varies by industry, and a ratio of less than one implies undervaluation. High returns on equity tend to result in higher price/book ratios.
A price-to-book ratio is a measure of value used by financial analysts and investors. It represents the market value of the estate relative to the book value of the estate and gives an idea of whether an investor is paying too much for what would be left if the company were to file for bankruptcy immediately. While a price/book ratio does not indicate anything about a company’s ability to generate profit for shareholders, it generally does serve to indicate whether a stock is overvalued or undervalued.
As with most ratios, the definition of what is a good price per book varies by industry. Companies that require more infrastructure capital, such as a manufacturing company, tend to trade at a lower price-to-book ratio than companies that require less capital, such as a consulting firm. A higher price/book ratio generally indicates that investors expect management to create more value from current assets, or that the market value of a company’s assets is significantly higher than book value.
There are two common ways to calculate the price-to-book ratio. The most common way to calculate it is by dividing the market value of the capital by the book value of the capital. Alternatively, the company’s market capitalization can be divided by the total book value included on its balance sheet. Price/book ratios can also be determined by calculating the spread between the return on equity and the required rate of return on your projects. Regardless of the method used, the price/book ratio will be the same; occurs as a single numeric value, also called a multiple.
A price-to-book ratio or multiple of less than one would imply that the company’s shares are priced below their book values in the market; In other words, the company is undervalued. Price/book ratios less than one are common in the case of economic inflation or when there is an underperforming market. When a company is overvalued, the price/book ratio will be greater than one. Historically, when the economy and stock markets are strong, companies have traded above a price-to-book ratio of two, indicating the potential for shares to be below their current book value.
There is a strong relationship between price/book ratios and returns on capital. Companies that have high returns on equity tend to sell above book value, while companies with low returns on equity tend to sell at or below book value. Investors generally should pay special attention to companies that show mismatched price/book ratios and returns on equity, low price-book ratios and high returns on equity, or vice versa.
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