So, we have already discussed the price-to-earnings (P/E) ratio. We will return to this indicator when discussing the investment rules of market gurus Benjamin Graham and Peter Lynch.
Today, I would like to discuss another multiplier, the price-to-book (P/B) ratio. For this, we need to delve a bit into the theory to understand what book value of equity is.
The Main Formula of the P/B Multiplier That You Need to Know
Actually, there is nothing complicated about the term book value of equity. Let’s imagine that Ivanov has a car worth 700,000 rubles and an apartment worth 3 million rubles. In addition, Ivanov has a mortgage with a remaining payment of 1 million rubles (including interest). He has nothing else.
In this case, Ivanov’s assets are: the value of the car + the value of the apartment, i.e., 700,000 + 3,000,000 = 3.7 million rubles. His debt is 1 million rubles. Therefore, to understand his equity, we need to subtract debts from assets, i.e., 3.7 million – 1 million = 2.7 million. This is how much Ivanov would get if he sold all his property and paid off his loan.
This gives the following picture:
Ivanov’s assets – Ivanov’s debts = Ivanov’s equity = 2.7 million
The same formula works for any company.
Company’s assets – Company’s debts = Company’s equity
or in other words,
Company’s assets = Company’s equity + Company’s debts
This is the main formula you must remember.
Company’s equity is also called shareholders’ equity. Thus, in the P/B formula, the denominator is the value of this shareholders’ equity, and the numerator is the company’s market capitalization (number of shares * price).
An ideal situation is when market capitalization equals the value of shareholders’ equity, i.e., P=B or P/B=1. This means that the market fairly evaluates the company’s value. However, in practice, it is usually more complex.
Analysis of a Specific Example
Let’s take an example of calculating the P/B ratio for Apple. On the closing date of January 12, 2020, the stock price of Apple was $128.80. The number of shares can be found in the balance sheet or through online information sources.
The number of shares was 16,976,760. Thus, the company’s market capitalization at the last closing price was 16,976.76 * 128.80 = $2.2T.
Now let’s look at the company’s shareholders’ equity. It was $65.3B. In this case, the price-to-book ratio is $2.2T / $65.3B = 33.7.
Now It Is Important to Understand Whether This Is High or Low?
To find out, it is necessary to compare the obtained value with the industry average, i.e., the average P/B ratio of Apple’s competitors. This can be found online. For example, here is one of the quite reliable sources. Apple belongs to the Computers/Peripherals sector, where the average P/B ratio is 22.90.
Conclusions: Apple’s P/B > Sector P/B, which means either the stock price of Apple is significantly overvalued compared to the industry, or the shareholders’ (equity) value is significantly undervalued. In this specific case, it is more likely the first (the price is too high). Therefore, based on this multiplier, Apple’s stocks are overvalued compared to the prices of its competitors.
FAQ
What is the P/B ratio?
The P/B ratio is a financial metric that compares a company’s market value to its book value, helping investors determine if a stock is overvalued or undervalued.
How is the P/B ratio calculated?
The P/B ratio is calculated by dividing a company’s market capitalization by its book value of equity.
Why is the P/B ratio important for investors?
The P/B ratio helps investors assess whether a company’s stock is priced fairly compared to its actual assets, providing insights into potential investment opportunities.
