Using The Price-To-Book Ratio As An Investment Analysis Tool

When it comes to making investment decisions, there are two main ways to go and these ways are tied to the objective of the investor or trader.

When it comes to making investment decisions, there are two main ways to go and these ways are tied to the objective of the investor or trader. For a trader, the wins lie in the quick gains that can be observed and leveraged over short term periods. For the investor, gains are attained from the growth in share price over a period of time as well. However, regardless of what side of the investing table you are on, the goal is to buy low and sell high.

The first issue lies in determining when the share price of a stock is low or high. Because of how price changes multiple times on a daily basis, it might be hard to account for all of the price changes. While you can view trends in price movements for a day, a month, a year, and even 5 years even on the Yochaa App, there is one key metric that gives you a snapshot of whether a price is overvalued or undervalued and that tool is the price to book ratio.

The price-to-book ratio is a financial ratio that is used to compare a company's current market price to its book value. The ratio measures the market's valuation of a company relative to its book value. For context, think of the book value as the total amount a company is worth if it sells all its assets and pays back all its liabilities. It is also important to note that the market value of equity is typically higher than the book value of a company.

Consequently, the price-to-book ratio is calculated by dividing one company’s stock price by its book value per share. When comparing two stocks – especially those with similar growth and profitability levels, the ratio can be useful for determining what stock has the best value at point in time based on its price and book value.

How Investors Use The Ratio

The P/B ratio is used by value investors to identify potential investment opportunities. When the price to book ratio of a company is less than one, it signifies that it trades for less than the value of its assets! What this means is that the investor has a margin of safety to hang on to as a true fundamental showing the company’s potentials. P/B ratios under 1 are typically considered solid investment and ratios above are considered to be overvalued. It is important to note here that the ratio being less than one could also serve as a signal for a troubled company. Hence, the ratio should be used as a part of a holistic stock analysis tool and not standalone. So, when next you stumble on a company’s financial summary on Bloomberg, you might want to have your eyes on the price to book ratio for a buying opportunity.

Written by Lawretta Egba.