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What is Price-to-Book Ratio?

Alvin Chow
Alvin Chow

There are so many investment metrics to choose from and it can be overwhelming for a beginner to decide which to use when evaluating a stock.

One of the most classic metrics to value a stock is the Price-to-Book Ratio or PB ratio in short.

Price is referring to the share price of the stock.

Book refers to the book value of a company. It is also known as Net Asset Value (NAV) or shareholders’ equity. The book value can be calculated by having the total assets less off the total liabilities. This is similar to how you would calculate your personal net worth – you have $2m assets but owe the banks $1m, your net worth would be $1m.

What is a good Price-to-Book ratio

Let’s run through 3 possible scenarios.

First, PB ratio = 1,

If we multiply Book Value on both sides of the equation, we get,

This means that the share price is trading at the company’s book value. We can say that the stock is fairly valued in this case.

Second, PB ratio more than 1,

If we multiply Book Value on both sides of the equation, we get,

This means that the share price is trading higher than the book value of the company and the share price is overvalued.

Third, PB ratio less than 1,

Again, if we multiply Book Value on both sides of the equation, we get,

This means that the share price is trading lower than the book value of the company and the share price is undervalued.

Hence, PB < 1 is a often considered a good indication of an undervalued stock.

When PB < 1 doesn’t apply, use PB trading range

But PB < 1 may not apply to some companies. The share prices may trade above the book value perpetually and hence there’s no chance for PB to go below 1.

Below is a screenshot from our Dr Wealth app for Ping An Insurance (SSE:601318). Its historical PB ratios have never dip below 1 for an example.

In such cases, analysts may plot the PB range of the stock and determine the average PB ratio as the new benchmark for undervaluation. For example, the average PB ratio for Ping An Insurance was 2.3 for the past 10 years (depicted by the red line in the chart below). Hence, we can determine that Ping An Insurance is undervalued when the PB ratio is below 2.3.

The advantage of using book value is that it is a stable number that doesn’t fluctuate wildly year-on-year. This cannot be said of other figures such as earnings or cash flow. Book value’s stability makes plotting a PB range chart possible.

Does Price-to-Book ratio work

It was proven in 1992 that PB ratio works. Nobel Laurette Eugene Fama and research partner, Kenneth French, co-published a research paper titled The Cross-Section of Expected Stock Returns. Instead of price-to-book value, Fama and French used an inverse of it, or book-to-market value. But they measure the same thing.

The research found higher book-to-market (or lower price-to-book) ratios deliver higher returns. I charted their findings below – group 1 and group 10 contained stocks with the highest PB ratios and lower PB ratios respectively. Group 10 has delivered the highest return relatively to other groups that had higher PB ratios.

This finding eventually led to the recognition of Fama-French three factor model and some investment funds have made this the foundation of their investment process.

When to use the Price-to-Book Ratio

PB ratios are very useful for real estate and financial companies because their underlying assets are valuable – properties and financial assets. The valuation of these assets are determined by established methodologies. These common standards and consistency are crucial to provide an air of trust in the valuation figures.

Accounting has been very good at valuing tangible assets but it has shown signs of weakness in valuing the digital economy. Tech companies are asset-light and the book values are often low (or might even be negative). This is because tech companies’ most valuable assets are their people, innovation ability and digital platforms which are not captured in the book value. Hence, PB ratio is not useful to value tech companies.

How to be increase the margin of safety of Price-to-Book ratio?

The father of value investing, Benjamin Graham, had a conservative version of PB ratio. He devised the Net Net Investing strategy and it has impacted the way value investors approach the stock markets even today. In his calculations, he only considered the most liquid assets such as cash (current assets) and disregarded long term assets such as properties. The Net Net value of a company will always be lower than its book value, thereby increasing the margin of safety. You can screen for Net Net stocks with our screener and if you need more help, you can consider this paid newsletter produced by Net Net Hunter.

We have also developed another version which we called it Conservative Net Assset Value (CNAV). In a similar vein, we only consider full value of good assets such as cash and properties and we discount other lower quality assets at 50%. You can read more about it here or see a demo during this webinar.

Conclusion

Price-to-book ratio is simple to use and it is widely available. A PB ratio of less than 1 usually implies the stock is undervalued but some stocks may never trade below PB 1. If so, we need to determine the average PB ratio based on its trading history. The stock is considered undervalued if it is trading below its average PB ratio.

While low PB ratios have been proven to deliver higher returns, it has also shown its limitations in the digital economy. Tech companies do not have much tangible assets or high book values. Hence, using PB ratios for tech companies aren’t appropriate. However, PB ratios are still relevant to value stocks with tangible assets such as properties and cash.

Alvin Chow
Alvin Chow
CEO of Dr Wealth. Built a business to empower DIY investors to make better investments. A believer of the Factor-based Investing approach and runs a Multi-Factor Portfolio that taps on the Value, Size, and Profitability Factors. Conducts the flagship Intelligent Investor Immersive program under Dr Wealth. An author of Secrets of Singapore Trading Gurus and Singapore Permanent Portfolio. Featured on various media such as MoneyFM 89.3, Kiss92, Straits Times and Lianhe Zaobao. Given talks at events organised by SGX, DBS, CPF and many others.
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