Why Does The Price-to-Book Ratio Matter?

There are many ways to value a company to determine how much it is worth, but the Price-to-Book (also called the Market-to-Book or Price-to-Equity) ratio is one of the most popular. This is basically a comparison of what the market supply and demand is for a business versus the actual valuation based on tangible assets. Each industry is different, but the price-to-book (P/B) ratio is a useful reality-check for most stocks and a preferred valuation method for some (like financial stocks).

Market versus Accounting Value

The market capitalization of a company is the stock price times the number of outstanding shares determined by supply and demand. Most stock investors are looking for the highest rate of return for their investment. They will look at the dividends paid and the potential resale value if a stock price goes up. They also might add in potential future revenue from a successful brand launch.

The accountant looks at the tangible assets including cash, deposits, equipment and land. The book value looks at what a business can receive on the open market for its physical assets if it were divided up.

Subtract the Intangible Assets, like Goodwill

The P/B ratio is just one of many financial numbers used to measure business worth. Here are the two primary ways to calculate the P/B ratio: 1) Company market capitalization divided by book value 2) Company share price divided by book value per share These two methods are really very similar.

Many financial experts will remove intangible assets, like goodwill for the valuation of a business. When a company goes bankrupt, these don't have any real value. The price-to-book should also be calculated on a "diluted" basis considering stock options.

Each industry has a range of values for these ratios. A lower P/B ratio suggests that management is not as efficient at turning investments into profits or assets.

Example of Toronto-Dominion Bank and Nova Scotia Bank

When NASDAQ.com does a company evaluation rating, it will consider the P/B and P/E ratios. A financial analyst might compare each company's numerical score to an industry standard score assigning a "Pass" or "Fail" grade.

Toronto-Dominion Bank, Royal Bank, Scotia Bank and CIBC are the largest Canadian banks. Let us look at the price-to-book ratio for two of these banks: Toronto-Dominion and Nova Scotia Bank. This will change daily, but for comparison purposes -- the stock price for Toronto-Dominion on July 15, 2013 was $82.00, the market capitalization was $75.8 billion and its P/B was 1.70. Also on July 15, 2013, The Bank of Nova Scotia had a stock price of $57.20, market capitalization of $68.1 billion and a P/B ratio of 1.76. As you can see, these two Canadian banks have very similar P/B ratios.

The value of a P/B ratio is to give you a solid starting point to evaluate the worth of a business. It works most effectively with financial firms where assets and liabilities are clearly laid out. This provides a glimpse of the efficiency of management in delivering profits to the shareholder. This is also essential when a firm goes bankrupt to determine fair market value of company assets.

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Josh Seco is a part-time financial blogger. Visit his site Equity-Research.com to find guides, tips and resources for equity research and investment banking.

Posted on 2013-07-25, By: Josh Seco *

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Note: The content of this article solely conveys the opinion of its author, Josh Seco