Price to Book Value Ratio – Formula, Meaning, Assumptions and Interpretation

Formula

Price to Book Value = Current Market Price / Total Assets – Intangible Assets

The value of assets is taken from the most recently published balance sheet.

Meaning

The price to book value ratio looks at an immediate liquidation scenario. Investors therefore compare the price that they are paying for the company against what they would receive if the business shut operations right away.

Assumptions

• Intangible Assets are Worthless: The price to book value excludes intangible assets from the calculation of book value. This can be misleading since intangible assets like patents can provide cash flows even if the company is being liquidated immediately.

• Tangible Assets are Represented at Fair Price: The ratio assumes that management have stated the assets at their fair book value i.e. there has been no manipulation using less depreciation to make the assets look overvalued.

Interpretation

The price to book value ratio can be used to make some serious interpretations about the business of the company and how the market is reacting to it. Here are some of the common interpretations made on the basis of price to book value ratio:

• Underpriced or Fundamentally Wrong: A lower price to book value ratio is a very rare occurrence. All companies that are traded on the stock exchange are usually valued above what they have in assets. However, when such a scenario arises, one of the two situations is true. Either the market has overlooked a possible free lunch or the market knows that there are some serious flaws in the fundamental nature of the business.

  The analyst must therefore look at a low price to book value ratio as a starting point to understand which of the two is the reality.

• Bankruptcy Bets: The price to book value has proved to be very useful for speculators making bankruptcy bets. A useful example of this would be the Satyam fiasco. When it was discovered that there was a fraud of huge magnitude in the company, everyone wanted to get rid of the share. In this mania, the stock price plummeted to an unrealistically low level.

  Investors who had an eye on the Price to Book Value ratio found that even if the company wound up its operations at its book value, they would still be left with more book value per share than the then prevailing market price per share. Such bets are usually risky because it is difficult to trust the book value stated on financials that have been admitted to be doctored with.