Price-to-book ratio: when book value is a useful anchor

The price-to-book ratio compares the market value of a company's equity with its accounting net worth, known as book value. It is one of the oldest valuation yardsticks and remains central for banks, insurers and other balance-sheet-driven businesses. It is much less useful for companies whose main assets, such as software, brands and know-how, do not appear on the balance sheet.

The formula

Book value = total assets - total liabilities   (= shareholders' equity)

P/B = share price / book value per share
    = market capitalization / shareholders' equity

Book value per share is shareholders' equity divided by shares outstanding. To read it you need the balance sheet; see how to read a balance sheet. A P/B of 1 means the market values the equity at exactly its accounting net worth. Above 1, the market values the business at more than its book value; below 1, at less.

A common variant is tangible book value, which subtracts goodwill and other intangible assets from equity. It asks what is left if you strip out items that may not be worth much in a stress scenario. See goodwill and intangible assets.

Example (illustrative numbers)

A company has a market capitalization of $6 billion. Its balance sheet shows total assets of $20 billion and total liabilities of $16 billion.

Book value = 20 - 16 = $4 billion
P/B        = 6 / 4  = 1.5

If $1 billion of those assets is goodwill, tangible book value is $3 billion and the price to tangible book is 2.0.

The link to ROE and P/E

P/B is not independent of profitability. It follows directly from two other ratios:

P/B = P/E x ROE

where ROE is return on equity, net income divided by equity. For example, a P/E of 12 together with a ROE of 10% gives a P/B of 1.2. This explains a sensible pattern: a business that earns a high return on its equity deserves to trade at a higher multiple of book than one earning a low return. In theory, a company that earns less than its cost of equity should trade below book, and one earning more should trade above it. See return on equity for how ROE is calculated and its pitfalls.

When P/B is a useful anchor

• Financial companies. For banks and insurers, assets and liabilities are largely financial instruments carried near fair value, so book value is a meaningful measure of net worth. P/B is a standard tool there, usually read together with ROE. See the financials sector.
• Asset-heavy businesses. Where value rests on tangible assets, such as certain industrial or real estate holdings, book value can serve as a reference point.
• A rough floor or reference. In some cases it indicates what might be recoverable if the business were wound down, although the real figure depends on what the assets would actually fetch.

When book value misleads

• Intangible-heavy companies. Spending on research, software and brand-building is generally expensed rather than recorded as an asset, so the most valuable resources often do not appear in book value. P/B ratios for such companies can look very high without signaling overvaluation.
• Buybacks and negative equity. Large share buybacks reduce equity, and some profitable companies end up with negative book value. P/B is then meaningless. Negative equity is one of the red flags on StocksXray stock pages.
• Historical cost. Assets are often recorded at what was paid, less depreciation. Land or a building bought decades ago may be worth far more than its book value; obsolete equipment may be worth less.
• Goodwill. After acquisitions, goodwill can make up a large share of equity. It can be written down later.
• Accounting estimates. For lenders, book value depends on loan-loss assumptions. A bank trading below book may be flagging doubts about the quality of its loans, not a bargain.

Rules of thumb

• A P/B below 1 is a question: are assets overstated, are returns low, or is the market too pessimistic?
• Compare P/B with ROE. Low P/B with persistently low ROE is not necessarily cheap.
• Compare within the same industry; P/B levels vary widely across sectors.
• Consider tangible book for financial and acquisitive companies.

Benjamin Graham's screening criteria for defensive investors famously included a moderate price relative to book value, often summarized as a P/B of no more than about 1.5, or a P/E times P/B product of no more than 22.5. These were written for a different era and a different mix of companies, so treat them as history and as an illustration of the idea, not a modern screen.

Common mistakes

• Comparing P/B across very different business models, such as a bank and a software firm.
• Reading a high P/B as overvaluation without checking ROE and intangible assets.
• Using book value from an old balance sheet after a large acquisition, impairment or buyback.

Key takeaways

• P/B equals market cap divided by shareholders' equity, and it equals P/E times ROE.
• It is most meaningful for banks, insurers and asset-heavy businesses.
• It is weak for companies whose value sits in intangibles, or whose equity is shrunk by buybacks.
• A low P/B needs an explanation; a high P/B needs a matching ROE.