Price to Book ratio or commonly known as P/B ratio is the ratio between the current market price of a share and the book value per share. So everyone is aware of the market price of a share and how the price fluctuates on increase or decrease of demand of share in the sare market.
P/B ratio = Market price per share/ Book value per share
What is Book Value?
In layman terms, book value is the difference between the assets and liabilities of a business.
Book Value = Assets – Liabilities
So if assets are more than liabilities than you end up with a positive book value and if the assets are lower than liabilities then you end up with negative book value.
Positive book value shows that you are in a good position and can pay off your liabilities. Negative book value means you are no longer capable of clearing your debts and your business has reached bankruptcy.
So once we get the book value of the firm, divide the book value with total outstanding shares.
Book value per share = Book Value of firm / Total outstanding shares
For example, a company has the following details:
Total outstanding share = 10
Market price per share = $20
Asset = $100
Liability = $50
So, Book Value of firm = Asset – Liability
Book Value = $100 – $50 = $50
Book Value per share = Book value of firm / Outstanding shares
Book Value per share = $50 / 10 = $5
hence, P/B ratio = Market price per share / Book vale per share
P/B ratio = $20 / $5 = 4
therefore P/B ratio = 4
This tells us that for every $1of asset you are ready to pay $4 i.e 4 times the asset value.
So P/B ratio is important but we need to understand when to use it to make investment decisions. As it is clear from the example that the P/B ratio is dependent on assets. So we need to understand the business model of a company before investing and figure out if the profit drivers are assets or not. Like in an IT firm, practically speaking they don’t have many assets and naturally, they have a low book value and higher P/B ratio.
P/B ratio is useful in case of companies which have high assets but we also need to make sure about the asset class the company has, is it appreciating asset or depreciating asset.