How to Use Price-To-Book Ratio?
What is Price-to-Book (P/B) Ratio?
Supposedly, you invested $ 10 million into a business.
1 year later, you made $ 1 million in profits and have paid yourself $ 0.5 million in dividends.
How much money do you now have inside your business?
The answer is $ 10.5 million. It is the addition of your capital of $ 10 million and retained earnings of $ 0.5 million. That $ 10.5 million is also known as equity or book value of your business after owning it for 1 year.
At that time, you met Mr. Tan, an astute businessman.
Mr. Tan is interested to buy over your business for $ 21 million. So, what does it mean? It means, Mr. Tan is offering you $2 for every $1 inside the business. The offer is valued at Price-to-Book (P/B) Ratio of 2.0. As such, P/B Ratio is a tool to compare a stock price with its book value on a per share basis.
= Stock Price / Book Value Per Share
What is Per Share Basis?
For instance, when you invested into the business, the business is a corporation which has issued 10 million shares. In other words, when you had invested $ 10 million into the business, you were effectively buying its shares at $1 per share.
After 1 year, your $ 1 million in profits equals $ 0.10 in earnings per share (EPS). Your $ 0.5 million in dividends would be $ 0.05 in dividends per share (DPS). So, the $ 10.5 million in equity (after 1 year) works out to be $ 1.05 per share.
Mr. Tan’s offer of $ 21 million is equivalent to $ 2.10 per share, which works out to be a multiple of 2.0 of book value per share of $ 1.05.
Thus, the following is a list of terminology used in financial reports:
|Basis: 100% Shareholdings||Basis: 1 Share|
|$ 10.5 million (Shareholders’ Equity)||$ 1.05
(Book Value per Share)
|$1.0 million(Shareholders’ Earnings)||$ 0.10
(Earnings per Share)
|$ 0.5 million(Dividends)||$ 0.05(Dividends per Share)|
|$ 21.0 million(Market Capitalisation)||$ 2.10
Therefore, the formula for P/B Ratio can also be:
= Stock Price / Book Value Per Share
= Market Capitalisation / Shareholders’ Equity
What does it Tell You?
In general, savvy investors (or businessmen alike) would aim to invest in a stock (or a business) when its P/B Ratio is low and aim to sell the stock is trading at a high P/B Ratio. This is because a low P/B Ratio indicates that a stock is cheap or undervalued and a high P/B Ratio indicates that a stock is overvalued.
Low P/B Ratio = Cheap & Undervalued
High P/B Ratio = Expensive & Overvalued
Here’s a familiar question:
I have two stocks.
Stock A is trading at $ 1.00 a share. Stock B is trading at $ 10.00 a share. Which of the two stocks is cheaper?
If you read my previous article on P/E Ratio, you will find that it is very possible for Stock B to be cheaper than Stock A despite Stock A being the lower-priced.
In this case, P/B Ratio would value the two stocks based on their book value or equity on a per share basis. Thus, if I were to inform you that the book value of Stock A and Stock B is $ 0.20 and $ 20.00 respectively, you would discover that Stock B is cheaper than Stock A based on the P/B Ratio formula.
This is because Stock B has a P/B Ratio of 0.50, which is lower than Stock A’s of 5.00.
|Stock Price||$ 1.00||$ 10.00|
|Book Value per Share||$ 0.20||$ 20.00|
|Current P/B Ratio||5.00||0.50|
How do I use P/B Ratio?
Here, I’ll offer two tips on how I personally use P/B Ratio.
First, I find that P/B Ratio is more useful as a valuation tool for stocks which are deriving their income from tangible assets (asset-based stocks). However, I find it to be less useful for stocks which depend on short-term contracts for income.
They are categorised as follows:
|Asset-Based Stocks||Contract-Based Stocks|
|– REITs- Banks- Insurance Companies – Utilities (Electricity, Water … etc)- Infrastructure (Highways, Railways … etc)- Plantation Stocks- Manufacturers of Evergreen Products||– Construction – Manufacturers of Technological Products- Oil & Gas Service Providers. – Property Developers (Small Scale Ones)- Business Solutions Providers|
Second, it involves three steps.
First, I will compile the book value per share of a stock for the last 10 years. For instance, let us use CapitaLand Mall Trust (CMT) as an example. For the past 10 years, its net asset value (NAV) – can be used interchangeably with book value – has increased consistently from S$ 1.53 in 2009 to S$ 2.00 in 2018. It is vital for a stock to report consistent growth in book value because a stock which reports consistent fall in book value is usually bad news than good, unless they are cash cows like Telcos and F&B Manufacturers.
Source: CMT’s Annual Reports
Second, I would calculate CMT’s P/B Ratio for each year over the past 10 years. Here, I use the final price of the closing date of CMT for each financial year. For instance, CMT’s financial year ends on 31 December for each year. Thus, I’ll use the stock price (at 31 December 2009) to calculate P/B Ratio at 2009 and would do the same for 2010, 2011, 2012 … 2018.
These stock price data can be sourced from Google Finance or Yahoo Finance or from a stock’s annual reports.
If I couldn’t locate the closing stock price on the exact date (31 December), I’ll use the stock price closest to 31 December.
Out of which, I would have the following:
- 10-Year Lowest P/B Ratio: 1.09 (2011)
- 10-Year Highest P/B Ratio: 1.30 (2012)
- 10-Year Average P/B Ratio: 1.14
As such, if I’m interested to invest in CMT, I would aim to invest in its units if its price is trading close to P/B Ratio of 1.09 and avoid buying them if its price is at P/B Ratio of above 1.14 or close to 1.30.
Thirdly, I would calculate CMT’s current P/B Ratio. As of 23 June 2019, units of CMT is trading at S$ 2.56. Its net asset value (NAV) per unit is S$ 2.04, as at 31 March 2019. Thus, its current P/B Ratio is 1.25, close to its highest P/B Ratio.
So, would you invest in CMT at S$ 2.56 a share today? You make the call.
Here, I’ll leave you with some takeaways:
- P/B Ratio compares stock price relative to its book value.
- Useful for Asset-Based Stocks, not Contract-Based Stocks.
- Calculate both current & 10-year P/B Ratio. Compare them.
- A stock is Undervalued if current P/B Ratio is below its average.
- A stock is Fairly Valued if current P/B Ratio is close to its average.
- A stock is Overvalued if current P/B Ratio is above its average.
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