In our previous lessons, we have highlighted the common rules for choosing shares and the procedure for analysis of the price-to-earnings (P/E) ratio. Today, we shall continue analyzing indicators that will help you to pick the best stocks to make money with.
The market-to-book ratio also referred to as the price-to-book ratio is a financial indicator used to measure the company’s current market capitalization relative to its book value.
In other words, we use this ratio to compare the company’s available net assets and the selling price of its shares.
The price-to-book value (P/B ratio) is commonly used by investors to indicate the market value of a particular share. This indicator comes in handy when evaluating companies that mostly consist of liquid assets (closed-end investment trusts, insurance, and banking companies).
This ratio is used to determine how much investors that invest in shares are paying for each dollar in net assets. The P/B ratio is calculated by dividing the company’s current stock price per share by its book value per share for a given period.
1. (BVPS) Share Price / Net Book Value per Share
2. Market Capitalization / Net Book Value
Let’s consider the example of data from Warren Buffet’s favorite company — Bank of America Corporation (BAC).
Each of the above approaches produced almost the same figure.
There are several opinions on the threshold values. Typically, a ratio that is less than 1 may indicate that the stock is potentially undervalued. If it stays within 1–2 range, the valuation is considered fair. In contrast, P/B that exceeds 3 may imply that the stock is overvalued.
With that said, all of this is pretty relative. In order to establish whether a stock is undervalued and whether investing in it will be a wise decision, you need to determine a specific P/B ratio that is considered “solid.” However, keep in mind that the P/B ratio which is deemed solid in terms of one industry may not be the same for another. This is why we recommend that you compare the ratio between companies belonging to the same industry.
Let’s consider a practical example illustrated by real figures of two world’s giants—Bank of America Corporation (BAC) and JP Morgan Chase (JPM) both of which operate in the banking sector.
Let it be reminded that investors at Gerchik & Co can trade stock CFDs of both of the aforementioned companies!
Given the industry-average figure of 0.74, here’s what we have:
1. Based on its P/B, Bank of America is undervalued. The stock’s current price-to-book value is at just 0.78. When compared to industry-average figures, ВАС’s stock value is slightly higher than that of other companies belonging to the same sector.
2. JP Morgan appears to be fairly valued with price-to-books value standing at 1.07. The drawback is that JPM value is higher as compared to figures of similar companies.
Investors typically consider this indicator to be very handy. However, you should keep in mind that the book value that is used in the calculation formula can change due to many factors, while low P/B may also imply that the company is experiencing fundamental problems. So, when choosing undervalued stocks against the backdrop of diverging opinions of investors, it makes sense to use other stock valuation methods in addition to or instead of P/B.
To perform an accurate analysis, we also recommend that you use ROE ratio which also involves net assets alongside Р/В.
In our next article, we will shed light on the price/earnings to growth ratio.