June 9, 2010

## 1. Introduction to price-to-book ratio (P/B)

Question: If I know the P/B ratio, the stockholders' equity and the total liabilities, how would I calculate the market value of assets?

The price-to-book ratio (P/B ratio) is a financial ratio that is used to compare a book value of the company to its current market price.

In other words, the P/B ratio is a measure of the share price relative to the value of the company's total assets minus total liabilities (per share). To be conservative, analysts sometimes remove intangible assets and goodwill from the equation as their value is significantly more subjective and often has no resale value. In fact, the P/B ratio is a "Price to Tangible Book Value."

A Price-to-Book Ratio can be calculated using the following formula:

 Price-to-Book Ratio (P/B) = Market Price per Share Balance Sheet Price per Share

Another formula that can be applied in the calculation of the Price-to-Book Ratio is as follows:

 Price-to-Book Ratio (P/B) = Market Capitalization Shareholders' Equity

A P/B ratio shows the market value for every dollar of tangible assets.

For example, a P/B ratio of 7 would mean that for every \$1 of tangible assets there is \$7 of market value. Thus, a low P/B ratio means that the stock is undervalued, whereas a high P/B ratio probably means that investors have high expectations for the company; hence, the stock is overvalued.

As any other ratio, the P/B ratios should be compared within industries. The P/B ratio analysis may work well in some industries and in some industries it may not (e.g. in such industries companies may own few tangible assets). An example of the latter may be big technology companies or software firms (e.g. Google).

## 2. Definition of accounting equation

Accounting equation is the basic equation of double-entry accounting that reflects the relationship of assets, liabilities and net worth (reserves + shareholders equity + retained earnings). The accounting equation shows that all assets are either financed by borrowing money or paid for with the money of the company's shareholders.

An accounting equation can be expressed using the following formula:

 Assets = Liabilities + Shareholders' Equity

Assets refer to what the business owns (equipment, supplies, cash, accounts receivable, etc.).

Liabilities express what the business owes to external parties (bank loan, accounts payable, etc.),

Owner's Equity shows what the owner(s) invested in the business (investment and business profit). Shareholders' equity is considered its book value.

## 3. Company market value using P/B ratio

Recall our question at the beginning of this article: if I know the P/B ratio, the stockholders' equity and the total liabilities, how would I calculate the market value of assets?

For example:

• P/B ratio = 3
• Equity = \$120,000
• Liabilities = \$230,000

The information above is sufficient if we want to determine the market value of the company without removing intangible assets (as noted in part 1) from the book value:

 P/B Ratio = Market Capitalization Shareholders' Equity

or

 Market Capitalization = Shareholders' Equity x P/B Ratio

Market Capitalization = \$120,000 x 3 = \$360,000

At the same time, if we would like to be more conservative in our calculations by considering intangible assets, then we do not have sufficient information in the question to find the answer.

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