Often we don't know How To Use The PB Ratio For Profitable Investment Decisions. But once you learn it can be really helpful. Here is the complete guide on the PB ratio.
Investing in stock is one of the most popular methods of earning a passive income. This requires a considerable time devoted to learning about investing and then individually analyzing the companies before investing. Financial ratios help to analyze the company’s performance and growth potential.
PB ratio or Price to book ratio is one of the most important financial ratios. It is used to calculate market capitalization to its book value. The actual value of the company after paying all the debts and liquidating all the assets can be assessed using the PB ratio.
In this blog, we will discuss How To Use The PB Ratio For Profitable Investment Decisions. We will cover the following in this blog.
The price-to-book (PB) ratio is used to compare a company’s market capitalization to its book value. When price per share is divided by book value per share the the PB ratio is obtained. Understanding how to use the PB ratio for profitable investment decisions is possible only when you know a stock is undervalued or overvalued. If the PB ratio is below 1 this shows the market is pricing the stock below its book value i.e. undervalued. If the PB ratio is more than 1 then the stock is overvalued. However, a higher PB ratio reflects the investor's confidence in the company’s growth potential.
How to use the PB ratio for profitable investment decisions isn't just about identifying high or low ratios. When you are planning to invest in a particular company, you should also check the PB of the other companies in that sector. Suppose the PB ratio of heavy sector companies is lower than that of tech companies with fewer tangible assets.
Moreover using other financial ratios with PB ratio provides a better understanding of the company’s work.
Calculating the PB ratio is simple if you once understand how it is done. If you learn to calculate you will learn how to use the PB ratio for assessing a company’s performance.
We will take the example of ABC Ltd to understand the calculation of PB ratio.
|
Particulars |
Figures in Rupees |
|
Price per share |
100 |
|
Total Equity |
600 |
|
Total outstanding shares |
20 |
|
BVPS* |
30 |
|
PB ratio^ |
3.33 |
This is the method of calculating the PB ratio however investors don't always need to calculate the PB ratio. All they need is to know how to use the PB ratio for stock analysis. Most of the websites give these metrics already.
Now that you have understood the meaning and calculation of the PB ratio, you need to understand its interpretation. We will be using the above example to explain this.
In the above example the PB ratio of ABC Ltd is 3.33 this means the investors are willing to pay Rs. 3.33 for Re.1 asset of the company. This is used to know whether the company is undervalued or overvalued.
For this, you have to compare the company's PB ratio with the other companies of the same sector or industry. Now either compare the PB ratio with individual peers or use the sector average. If the pb is more than the sector average the company is overvalued. If the PB ratio is less than the sector average then the stock is undervalued.
People often ask, “What is the Ideal PB ratio?
We must understand it is not advisable to compare the PB ratio of a company from one sector to another. But conventionally, a PB ratio of less than 1 shows the stock is undervalued. PB ratio is more than 1 means it is overvalued.
Checking the PB ratio is most useful for sectors like banking and finance when the book value is a good representative of market value.
Once you have done the analysis of the PB ratio of the company, further shortlist the companies with high cashflow generation capacity and low DE ratio and future growth. You to further shortlist the companies with higher debt or poor growth visibility. Once you know how to use the PB ratio with other ratios finding the right company to invest in becomes much easier. We will soon come up with more such topics so stay tuned. Follow us on LinkedIn for more updates on blogs and E-books.
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