P/B ratio

Last updated

The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's current market value to its book value (where book value is the value of all assets minus liabilities owned by a company). The calculation can be performed in two ways, but the result should be the same. In the first way, the company's market capitalization can be divided by the company's total book value from its balance sheet. The second way, using per-share values, is to divide the company's current share price by the book value per share (i.e. its book value divided by the number of outstanding shares). It is also known as the market-to-book ratio and the price-to-equity ratio (which should not be confused with the price-to-earnings ratio), and its inverse is called the book-to-market ratio.

Contents

As with most ratios, it varies a fair amount by industry. Industries that require more infrastructure capital (for each dollar of profit) will usually trade at P/B ratios much lower than, for example, consulting firms. P/B ratios are commonly used to compare banks, because most assets and liabilities of banks are constantly valued at market values. A higher P/B ratio implies that investors expect management to create more value from a given set of assets, all else equal (and/or that the market value of the firm's assets is significantly higher than their accounting value). P/B ratios do not, however, directly provide any information on the ability of the firm to generate profits or cash for shareholders.

This ratio also gives some idea of whether an investor is paying too much for what would be left if the company went bankrupt immediately. For companies in distress, the book value is usually calculated without the intangible assets that would have no resale value. In such cases, P/B should also be calculated on a "diluted" basis, because stock options may well vest on sale of the company or change of control or firing of management.

Total book value vs tangible book value

Technically, P/B can be calculated either including or excluding intangible assets and goodwill. [1] When intangible assets and goodwill are excluded, the ratio is often specified to be "price to tangible book value" or "price to tangible book".[ citation needed ] See also Return on tangible equity.

Applications and limitations

In the 1920s and '30s when investors like Benjamin Graham outlined the concepts of value investing and estimating a company's value, book values were more relevant than in later years. Most companies in this era had significant investments in tangible assets, and such assets comprised the bulk of the value of the company. The value of today's companies, other than asset based companies like investment trusts and property companies, is very different from the book values and there is often no relationship between their intrinsic values and their book values. In his 2000 annual report, Graham disciple Warren Buffett said "In all cases, what is clear is that book value is meaningless as an indicator of value". [2] [3]

Except in the case of a small minority of companies, like property companies and investment trusts that are asset-based, book values can bear little or no relationship to true values of the companies. The items on a company's balance sheet are the result of various transactions, recorded using double-entry bookkeeping at a particular point in time, to the extent that they do not form part of the profit and loss account to that point in time. The assets and liabilities comprising the book value are mainly stated at historic cost though a few items therein may be stated at valuations.

In many of today's companies,[ weasel words ] their most valuable assets are not shown on the balances sheet and are therefore not necessarily reflected in the company's book value. In these types of companies, factors such as copyrights, intellectual capital, internally generated goodwill, or brand awareness are much more valuable than the tangible assets listed on their balance sheets. This generally leads the company's market value to be higher than its book value.[ citation needed ]

Despite the limitations of the price-book ratio, academic research has repeatedly shown that stocks with low price-book ratios tend to outperform stocks with high price-book ratios in the United States and other nations. [4] [5] [6] [7] [8] Eugene Fama and Kenneth French incorporated a price-book term in their influential three factor model. Penman Richardson and Tuna (2013) show how the price-to-book ratio can be decomposed into financing and operating components. Foye and Mramor (2016) show that while stocks with low price-book ratios normally outperform, the ratios decomposed elements exhibit a different relationship with returns in different countries, implying that the price-book ratio may have a country-specific interpretation. [9]

Related Research Articles

<span class="mw-page-title-main">Dividend</span> Payment made by a corporation to its shareholders, usually as a distribution of profits

A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a proportion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-invested in the business. The current year profit as well as the retained earnings of previous years are available for distribution; a corporation is usually prohibited from paying a dividend out of its capital. Distribution to shareholders may be in cash or, if the corporation has a dividend reinvestment plan, the amount can be paid by the issue of further shares or by share repurchase. In some cases, the distribution may be of assets.

Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.

<span class="mw-page-title-main">Equity (finance)</span> Ownership of property reduced by its liabilities

In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets. For example, if someone owns a car worth $24,000 and owes $10,000 on the loan used to buy the car, the difference of $14,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business. A business that needs to start up or expand its operations can sell its equity in order to raise cash that does not have to be repaid on a set schedule.

In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be "tangible book value".

<span class="mw-page-title-main">Valuation (finance)</span> Process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the present value (PV) of an asset. In a business context, it is often the hypothetical price that a third party would pay for a given asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability.

In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.

Tobin's q, is the ratio between a physical asset's market value and its replacement value. It was first introduced by Nicholas Kaldor in 1966 in his paper: Marginal Productivity and the Macro-Economic Theories of Distribution: Comment on Samuelson and Modigliani. It was popularised a decade later by James Tobin, who in 1970, described its two quantities as:

One, the numerator, is the market valuation: the going price in the market for exchanging existing assets. The other, the denominator, is the replacement or reproduction cost: the price in the market for newly produced commodities. We believe that this ratio has considerable macroeconomic significance and usefulness, as the nexus between financial markets and markets for goods and services.

<span class="mw-page-title-main">Value investing</span> Investment paradigm

Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham and David Dodd at Columbia Business School in 1928, and subsequently developed in their 1934 text Security Analysis.

Net asset value (NAV) is the value of an entity's assets minus the value of its liabilities, often in relation to open-end or mutual funds, since shares of such funds registered with the U.S. Securities and Exchange Commission are redeemed at their net asset value. It is also a key figure with regard to hedge funds and venture capital funds when calculating the value of the underlying investments in these funds by investors. This may also be the same as the book value or the equity value of a business. Net asset value may represent the value of the total equity, or it may be divided by the number of shares outstanding held by investors, thereby representing the net asset value per share.

Contrarian Investing is an investment strategy that is characterized by purchasing and selling in contrast to the prevailing sentiment of the time.

In finance, leverage is any technique involving borrowing funds to buy things, hoping that future profits will be many times more than the cost of borrowing. This technique is named after a lever in physics, which amplifies a small input force into a greater output force, because successful leverage amplifies the comparatively small amount of money needed for borrowing into large amounts of profit. However, the technique also involves the high risk of not being able to pay back a large loan. Normally, a lender will set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan.

An undervalued stock is defined as a stock that is selling at a price significantly below what is assumed to be its intrinsic value. For example, if a stock is selling for $50, but it is worth $100 based on predictable future cash flows, then it is an undervalued stock. The undervalued stock has the intrinsic value below the investment's true intrinsic value.

<span class="mw-page-title-main">Financial statement analysis</span>

Financial statement analysis is the process of reviewing and analyzing a company's financial statements to make better economic decisions to earn income in future. These statements include the income statement, balance sheet, statement of cash flows, notes to accounts and a statement of changes in equity. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, financial health, and future prospects of an organization.

<span class="mw-page-title-main">Goodwill (accounting)</span> Intangible asset

In accounting, goodwill is an intangible asset that arises when a buyer acquires an existing business. Goodwill represents assets that are not separately identifiable. Goodwill does not include identifiable assets that are capable of being separated from the entity regardless of whether the entity intends to do so. Goodwill also does not include contractual or other legal rights regardless of whether those are transferable from the entity or other rights and obligations.

Quality investing is an investment strategy based on a set of clearly defined fundamental criteria that seeks to identify companies with outstanding quality characteristics. The quality assessment is made based on soft and hard criteria. Quality investing supports best overall rather than best-in-class approach.

In asset pricing and portfolio management the Fama–French three-factor model is a statistical model designed in 1992 by Eugene Fama and Kenneth French to describe stock returns. Fama and French were colleagues at the University of Chicago Booth School of Business, where Fama still works. In 2013, Fama shared the Nobel Memorial Prize in Economic Sciences for his empirical analysis of asset prices. The three factors are (1) market excess return, (2) the outperformance of small versus big companies, and (3) the outperformance of high book/market versus low book/market companies. There is academic debate about the last two factors.

<span class="mw-page-title-main">Asset</span> Economic resource, from which future economic benefits are expected

In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything that can be used to produce positive economic value. Assets represent value of ownership that can be converted into cash . The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business.

Purchase price allocation (PPA) is an application of goodwill accounting whereby one company, when purchasing a second company, allocates the purchase price into various assets and liabilities acquired from the transaction.

<span class="mw-page-title-main">Financial ratio</span> Numerical value to determine the financial condition of a company

A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

Factor investing is an investment approach that involves targeting quantifiable firm characteristics or “factors” that can explain differences in stock returns. Security characteristics that may be included in a factor-based approach include size, low-volatility, value, momentum, asset growth, profitability, leverage, term and cost of carry.

References

  1. ↑ Graham and Dodd's Security Analysis, Fifth Edition, pp 318 - 319
  2. ↑ "Book values".
  3. ↑ "Filters, sieves & screes".
  4. ↑ Carlo Capaul, Ian Rowley & William F. Sharpe (1993) International Value and Growth Stock Returns, Financial Analysts Journal, 49:1, 27-36, DOI: 10.2469/faj.v49.n1.27
  5. ↑ Oppenheimer, Henry R. “A Test of Ben Graham's Stock Selection Criteria.” Financial Analysts Journal, vol. 40, no. 5, 1984, pp. 68–74. JSTOR, www.jstor.org/stable/4478776. Accessed 7 Mar. 2021.
  6. ↑ Eugne Fama and Kenneth French. The Cross-Section of Expected Stock Returns, Working Paper 333, Graduate School of Business, University of Chicago, January 1992.
  7. ↑ S. Basu. "Investment Performance of Common Stocks in Relation to Their Price/Earnings Ratios: A Test of the Efficient Market Hypothesis", Journal of Finance 32(3), June, 1977.
  8. ↑ Institute, Brandes, Value vs. Glamour: A Global Phenomenon (October 15, 2008). Brandes Institute Research Paper No. 2008-06, Available at SSRN: https://ssrn.com/abstract=1289357 or http://dx.doi.org/10.2139/ssrn.1289357
  9. ↑ Foye, James; Mramor, Dusan (20 May 2016). "A New Perspective on the International Evidence Concerning the Book-Price Effect". SSRN   2782441.{{cite journal}}: Cite journal requires |journal= (help)

This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.