The price to book value ratio, or PBV ratio, compares the market and book value of the company. Imagine a company is about to be liquidated. It sells of all its assets, and pays off all its debts. Whatever is left over is the book value of the company. The PBV ratio is the market price per share divided by the book value per share. For example, a stock with a PBV ratio of 2 means that we pay Rs 2 for every Rs. 1 of book value. The higher the PBV, the more expensive the stock.
Most companies have a PBV greater than one. This means that its market value is higher than its book value. Why is this the case? There are two reasons:
First, investors will pay a premium above the book value if the company is expected to generate enough earnings in the future. These earnings justify a market value above the book value.
Second, the book value of the firm may not be up to date. For example, the value of an asset on a company’s balance sheet often reflects what the firm paid for the asset. This is not necessarily what the asset is currently worth. The best example of this is property, which typically increases in value over time. In this case, the true book value is higher than what the financial statements imply.
The PBV is most relevant for firms that are close to liquidation or bankruptcy. If a firm is liquidated, shareholders receive the book value. Once caveat here is that the bankruptcy process is costly. There is no guarantee that shareholders receive the entire book value for a liquidated firm.
The PBV ratio is more useful for firms that hold assets of tangible value. Manufacturing firms are a good example. They hold property, machinery, plants, etc. For firms with few tangible assets, the book value is less relevant. For example, companies that consists solely of employees, computers, and office space, don’t have a meaningful book value.
The Price – Book Value Ratio Formula
The PBV ratio is the market price per share divided by the book value per share. The market price per share is simply the stock price. The book value per share is a firm’s assets minus its liabilities, divided by the total number of shares.
PBV ratio = market price per share / book value per share