Market to Book Ratio

The price-to-book (P/B) ratio, also known as the market-to-book (M/B) ratio, is a financial indicator used to compare a company's book value to its current market value.

The market value, the value associated with the company in question, is represented by the current stock price of all outstanding shares. After the company liquidates all of its assets and pays off all of its liabilities, the remaining sum is referred to as the book value.

Since book value measures the net asset value investors receive when they purchase a share of a company, many investors pay closer attention to it than the market value because it reveals the true financial strength of a company.

The reason it reveals the true financial strength of a company since the book value of a share of stock is defined as the amount that might be distributed to shareholders if a company is liquidated and all outstanding debts are paid.

Another reason why the P/B ratio is important for investors is because it conveys a clear overview for investors seeking growth at a reasonable price. In other words, searching for sustainable, strong businesses which are undervalued. 

Investors look closely at this ratio alongside return on equity since ROE also measures the profitability of a business concerning equity. Or as the return for investors if you deduct the liabilities from the assets. 

A large difference between ROE and P/B ratio can be a huge red flag for investors. It shows that security is overvalued. 

The difference between a corporation's assets and liabilities is its book value. 

Market-to-Book Ratio Formula

By dividing the stock's most recent closing price by the book value per share for the most recent quarter, one can get the market-to-book ratio.

The Market to Book formula is as follows:

Market Capitalization / Net Book Value

or

Share Price / Net Book Value per Share

Where Net Book Value = Total Assets – Total Liabilities

Investors use this ratio to understand how the market values a certain security. The use of this ratio is widely implemented in the finance industry.

However, remember that this ratio is least effective when used on intangible assets, meaning it's a type of asset with non-monetary or physical substance. 

For example, a company spending billions on marketing can increase sales. However, this expense will reduce the company's book value due to accounting principles that follow a more conservative approach.

Example to make things clear: Let us look at a technology company called XYZ Ltd, which is a publicly-traded company. Company XYZ has 10,000 outstanding shares on the market with a share price of 20$. In addition, the company reported that it has a net worth of 500,000$ on its balance sheet.

We can use the above formula to calculate the Market Book ratio (M/B).

Book value = $500,000

Market capitalization = 20 x 10,000 = $200,000

M/B = 200,000/500,000

M/B = 0.4 

This shows that the company may be undervalued. It also depends on the financial metrics of companies in the same sector.

Interpreting Market-To-Book Ratio Price Book

Interpreting this financial metric is extremely important to check if the investment we are considering making is financially worth it. Now keep in mind that the market value is usually higher than a company's book value. 

As a result, a low ratio-typically less than 1-can suggest that a stock would not be a good investment. Additionally, if the ratio is high-typically greater than 1-it may indicate that the stock has fared well, making it a favorable investment.

The low ratio is usually an indicator that the investment is particularly poor because it conveys that you are most likely overpaying for the company's net assets or what would be left over if the business decided to sell its assets and pay its liabilities.

Furthermore, companies in serious financial distress or bankruptcy will have a reduction in net assets, causing the ratio to be less than one.

A company may use the market-to-book ratio to determine whether the value of its assets and stock market price is comparable. 

It is ideal for comparing Market-to-Book Ratios among businesses in the same sector. Using this financial metric is also useful when looking for undervalued stocks. 

Conclusion

Market-to-book ratio is an important metric that investors use to look out for potential investment opportunities. 

This ratio is crucial since it can inform investors whether a company's market price appears acceptable in light of its balance sheet. For example, if a company sells all of its assets and pays off its liabilities, the net assets of the company are what the shareholders get when they purchase a share of stock.

The ratio is most effective when comparing companies within the same sector. However, using that ratio with intangible assets can be tricky and counterintuitive due to conservative accounting standards when dealing with expenses.

If a stock's ratio is less than 1, that can mean that the stock is undervalued since its book value is higher than the market value or the market price of the shares. The investor is receiving more "bang for his/her buck" by paying less for an item than its actual worth, which in this case, is higher.

Companies with exceptionally low ratios might be going through periods of bankruptcy or financial distress, where the company is forcibly selling its assets to pay its debts. Also, when the ratio is higher than 1, an investor might conclude that this security is overvalued, deciding to avoid it.

Researched and authored by Mohammad Ezzeddine | Linkedin

Reviewed and Edited by Raghav Dharmarajan

Free Resources

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