Definition
The Price/Book (P/B) Ratio is a ratio used to compare a stock’s market value to its book value. The ratio is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share. This metric is widely used by securities analysts and money managers to determine whether a stock is undervalued or overvalued.
Formula
\[ \text{Price/Book Ratio} = \frac{\text{Market Price per Share}}{\text{Book Value per Share}} \]
Interpretation
- High P/B Ratio (≥ 3): Often represents a popular growth stock. These stocks usually possess high market valuations relative to their book value.
- Low P/B Ratio (<1): Indicates that the stock is trading below its book value, attracting value-oriented investors who believe the stock is undervalued.
Examples
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Growth Stock:
- ABC Corp has a market price of $120 per share and a book value of $30 per share.
- P/B Ratio = \( \frac{120}{30} = 4 \)
- The high P/B ratio indicates that ABC Corp is highly valued by the market, likely due to strong growth expectations.
-
Value Stock:
- XYZ Ltd. has a market price of $40 per share and a book value of $50 per share.
- P/B Ratio = \( \frac{40}{50} = 0.8 \)
- With a P/B ratio less than 1, XYZ Ltd. appears undervalued, potentially making it attractive to value investors.
Frequently Asked Questions (FAQs)
What does a low Price/Book Ratio indicate?
A low P/B Ratio, typically less than 1, suggests a stock is undervalued as it is trading below its book value. It can attract value-oriented investors who seek to buy undervalued stocks with a margin of safety.
How is the book value per share calculated?
Book value per share is derived by dividing the company’s total equity by the number of outstanding shares. It represents the equity value attributable to each share if the company were liquidated at its book value.
Can a high Price/Book Ratio also be risky?
Yes, a high P/B Ratio may indicate that a stock is potentially overvalued, which could pose risks if the company’s growth prospects don’t meet market expectations.
Is the P/B Ratio applicable to all industries?
No, the P/B Ratio is particularly useful for valuing companies with significant tangible assets such as finance, manufacturing, and industrial firms. It’s less effective for companies in sectors with high intangible assets like technology or services.
What other metrics should be used alongside the P/B Ratio?
Other metrics such as Price/Earnings (P/E), Earnings Per Share (EPS), Return on Equity (ROE), and the Debt/Equity Ratio can provide additional insights into a company’s financial health and valuation.
Related Terms and Definitions
- Book Value: The net asset value of a company, calculated as total assets minus intangible assets (patents, goodwill) and liabilities.
- Growth Stock: Shares in a company expected to grow at an above-average rate compared to other companies.
- Value Investing: An investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value.
- Market Price: The current price at which an asset or service can be bought or sold.
Online References
Suggested Books for Further Studies
- “Security Analysis” by Benjamin Graham and David Dodd
- “The Intelligent Investor” by Benjamin Graham
- “Valuation: Measuring and Managing the Value of Companies” by McKinsey & Company Inc., Tim Koller, Marc Goedhart, and David Wessels
Fundamentals of Price/Book Ratio: Investment Analysis Basics Quiz
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