Definition of Price to Book Value
Price-to-book, or PB, ratio is a financial analysis ratio used to compare the book value of a firm's assets with the market value. As an accounting term, book value refers to total assets minus total liabilities. There are two different approaches to calculating PB. The most common way is dividing a company's market capitalization by the company's total book value. Another way is to divide the current share price by the book value per share. Both calculations render the same answer.
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History
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Investors are always looking for value. Considered the father of value investing, Benjamin Graham was the first to make the PB ratio popular. He was able to show that low PB stocks generate higher returns than the market on average. Disciples of Graham include Warren Buffett, William J. Ruane, Irving Kahn and Hani M. Anklis. Buffet and Kahn even named sons after Graham.
Calculation
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The balance sheet shows the mix of debt and equity used to finance assets on a balance sheet. The book value represents the original value of the assets as purchased. It is also the difference between a company's assets and liabilities. The price or the market capitalization is the value of assets based on the market. The ratio between the market price of assets and the book value of assets or market capitalization (stock price) / book value (book value per share).
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Significance
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The PB ratio provides investors with a price tag by comparing the book (original) value of an organization's assets to the market (trading) value of an organization's assets. The actual ratio is calculated by dividing market capitalization (or stock price) by the book value of equity on the firm's balance sheet (per share if compared against stock price).
Interpretation
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Stocks or firms that trade at a PB of less than one are considered undervalued. Investors also believe that book value is equivalent to liquidation value. Why aren't these companies with PB's of less than one being taken over or bought out? Due to accrual accounting, there is often a discrepancy between market value and book value, which increases risk.
Risks
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Investing in low PB companies can potentially expose investors to additional market risk. In his book "Investment Fables," Aswath Damodaran compares low PB firms with the rest of the market. His research showed that as a group, low PB stocks have a higher degree of volatility and usually have more debt compared to capital.
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References
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