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Understanding concepts of Price to Book-Value (P/B) Ratio
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In this blog we try to understand the P/B ratio which we commonly called Price to Book Ratio.

The price-to-book ratio or we can say P/B ratio is a financial ratio commonly used to make comparison between company’s current market price to its book value. It is also expressed as a multiple (i.e. stock is traded at how many multiple). Ratio is also known as “PRICE TO EQUITY RATIO”.

It is calculated as current market price of share is divided by book value per share.

Price-equity Ratio or P/B Ratio = Current Market Price of Share / Book Value per Share

Where, Book Value per Share = Net Worth / Number of shares outstanding

Also, Net worth = (Total Assets - Total Liabilities)

Lower P/B implies that stock is undervalued. However it also means that there is something wrong in the fundamentals of company. As with most ratios, be aware that this varies by industry.

This ratio also gives idea about how much we are paying for a stock, also gives us idea about how much we get if company went bankrupt.

Breaking Down' Price-equity Ratio or P/B Ratio'

The Price-to-Book value ratio reflects the value that market participants attach to a company's equity relative to its book value of equity. A stock's market value is a forward-looking metric that reflects a company's future cash flows. The book value of equity is an accounting measure that is based on the historic cost principle, and reflects past issuances of equity, augmented by any profits or losses, and reduced by dividends and share buybacks.

Understanding the basic difference between Book Value and Market Value

Book Value of share is calculated from balance sheet, it is calculated as difference between a company’s total asset and total liabilities, or we can say book value is also called as actual purchasing cost of an asset, whereas market value of share is derived from stock market there is premium added in this. Market value is calculated by multiplying total no of outstanding share by the current market share of company. Market value is the price that could be obtained by selling an asset on a competitive, open market.

Merit and Demerits to the P/B Ratio

Long term investors find that Price to book value ratio is useful because the book value of equity provides a relatively stable and intuitive metric that can be easily compared to the market price. Also, the P/B ratio can be used for firms with positive book values and negative earnings since negative earnings render price-to-earnings ratios useless, and there are fewer companies with negative book values than companies with negative earnings. However, when accounting standards applied by firms vary, P/B ratios may not be comparable, especially for companies from different countries. Also, P/B ratios can be less useful for services and information technology companies with little tangible assets on their balance sheets. Finally, the book value can become negative as a result of a long series of negative earnings, making the P/B ratio useless for relative valuation purposes.

Illustration: Estimating the PBV ratio for a stable firm with dividends- Amoco

Amoco had earnings per share of $3.82 in 1994, and paid out 60% of its earnings as dividends that year. The growth rate in earnings and dividends, in the long term, is expected to be 6%. The return on equity at Amoco in 1994 was 15%. The beta for Amoco is 0.65 and the Treasury bond rate is 7.5%.

Current Dividend Payout Ratio = 60%

Expected Growth Rate in Earnings and Dividends = 6%

Return on Equity =15%

Cost of Equity = 7.5% + 0.65*5.5% = 11.08 %

PBV Ratio based on fundamentals = 0.15 * 0.60 *1.06 / (.1108 -.06) = 1.88

PBV Ratio based upon return differential = (0.15 - 0.06) / (0.1108 - 0.06) = 1.77

Amoco was selling at a P/BV ratio of just about 2.00 on the day of this analysis. (March 1995)

P/BV and ROE for Oil Companies - 1995 

Company

Price per Share

BV per share

Price/BV

ROE

Elf Aquitane

36

29.6

1.22

5.0%

Amerada Hess

45

32.65

1.38

3.5%

Getty

12

8.15

1.47

11.0%

Murphy Oil

42

27.95

1.50

7.5%

Ashland Oil

34

21.23

1.60

12.4%

Repsol

27

15.35

1.76

15.5%

Royal Dutch

107

58.95

1.82

12.0%

Texaco

61

33.15

1.84

11.0%

Occidental Pete

19

9.95

1.91

9.5%

Mobil

85

44.5

1.91

13.0%

Chevron Corp

44

22.2

1.98

13.0%

Amoco

59

28.85

2.05

15.0%

Exxon Corp

62

28.3

2.19

15.0%

British Petroleum

80

33.6

2.38

15.0%

Unocal

27

11.3

2.39

13.0%

Atlantic Richfield

103

38.9

2.65

 

 

OIL COMPANIES: P/BV AND ROE

Correlation between PBV Ratios and ROE = 0.78

Regression: PBV = 0.91 + 8.26 (ROE) R2 = 0.61

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