While both the P/E and P/S ratios compare the stock’s price to statistics
from a company’s income statement (also known as the profit and loss
statement), the price/book (P/B) ratio draws on the balance sheet. While
income and cash-flow statements report quarterly numbers that will
combine to reflect annual performance, balance sheets simply take a
snapshot of the company at a particular time.
To calculate the P/B ratio, divide the stock’s market capitalization by the
book value, or equity. For example, at the end of August 2013, Pfizer traded
at 2.6 times book value—the lowest among the four drug stocks in the table.
You’ll find the book value on the balance sheet. But instead of summing the
equity for the last four quarters, just use the most recent period.
Equity represents assets minus liabilities. In other words, if a company
owns $10 billion in assets, and also owes $5 billion, it has $5 billion in
equity. Equity—sometimes called shareholders equity or common equity—
should reflect the company’s liquidation value in theory. If the company
goes bankrupt and sells its assets to pay its creditors, it should be left with
assets that equal the equity balance.
Of course, because of accounting rules and other factors, book value only
estimates liquidation value, and for most companies the estimate would be
very rough. The book value of an asset reflects its original cost and may not
keep pace with changes in the asset value, either because of inflation,
depreciation, or a change in the asset’s ability to generate revenue.
That said, the P/B ratio still serves as a useful check of other valuation
methods. A stock cheap on P/E and P/S should probably look good based on
P/B as well. This won’t always occur, but a discrepancy between multiple
valuation ratios should raise a flag. In other words, if the stock sports a low
P/E but trades at a premium to its peers on P/S and P/B, you’d be wise to
learn the reason why before you buy it.
Consider the following when analyzing P/B ratios:
Only a few companies have negative equity values, which means you
can use the ratio with more companies than you can with the P/E ratio.
P/B works best with traditional businesses that own hard assets—
things like factories, machinery, and warehouses full of inventory.
Accounting rules also tend to keep equity from fully reflecting the value
of intangible assets like patents and other intellectual property. For
companies with most of their value tied up in brand names and other
intangible assets, book value has little in common with the intrinsic
value of the company.
For companies with extremely heavy debt loads—or ones that have
posted serious enough losses to erode the value of equity—the P/B
ratio can appear inordinately high.
Price/Book Ratio.
