Question

Show the calculation for price to book ratio, give an example and discuss how to use it as a way to determine valuation for common stock?

Answer 1

Price to Book value is the ratio of Price to Book value per share.

This ratio is often interpreted as an indicator of market judgement about relationship between a company's required rate of return and its actual rate of return. Assuming that book value reflect the fair values of the assets, a P/B ratio of one can be interpreted as an indicator that the company's future returns are exactly equal to the return required by the market.

If P/B > 1 implies future profitability of the company is expected to exceed the required rate of return

If P/B < 1 implies future profitability of the company is not expected to exceed the required rate of return

Relative valuation using comparables:

Also this P/B of one company is compared with the P/B ratio of other company. If P/B ratio of A is lower than the other company B then we can conclude that the stock of A is attractively valued. But this has to be used along with other ratios also.

For eg:

Price per share of company A = 15.85 euros

Book value of common shareholders' equity = 19.6 billion euros

Weighted average number of shares outstanding = 4646 millions

Book value per share = 19.6/4.646 = 4.2186

P/B = 15.85/4.2186 = 3.76, implies future profitability of the company is expected to exceed the required rate of return

Also If P/B of another company B is 4, then Stock A will be more attractive than B