One of the most important technical indicators to value investors is the P/B ratio, or the Price to Book ratio. This ratio effectively describes the fundamental value of a company relative to its balance sheet. This strategy has been largely pioneered by the most famous value investors of all, Benjamin Graham and Warren Buffet. The P/B ratio, used in conjunction with other metrics and evaluations, can lead to the discovery of a solid value stock to add to your portfolio.
The P/B ratio
Quite simply, the P/B ratio is the price of the stock, divided by the stock’s book value. The book value is the balance sheet valuation of the company divided by the number of shares of the company’s stock in the stock market. Here is the formula:
Book Value = (Assets - Liabilities) / Number of Shares
The book value basically tells an investor what the company’s assets are worth (but doesn’t include intangible assets such as patents). The book value is important because it gives an indicator as to what the stock should be fairly priced at.
Warren Buffett, the greatest value investor of this century, now tends to buy stocks with a P/B ratio of around 1.3.
For example, if company A is priced at $500, but its book value is $250, then its P/B ratio would be 2.00. Thus, the stock price is double the book value. Ignoring growth or other factors, this stock could not be characterized as a value investment. It is overbought, meaning the share price is much higher than what it should be. This is reflected in the very high P/B ratio. Warren Buffet would likely not buy this stock.
If company B is priced at $30, and its book value is $30, then its P/B ratio would be 1.00. Thus, the stock price is equal to the book value. As long as the company has a good future outlook, and a sustainable business plan, for example, then this would qualify as a value investment. The P/B ratio indicates a fairly priced stock.
Finding Stocks with Fair P/B ratios
When the stock market is overbought, P/B ratios will be inflated above their normal levels as stock prices are much higher than the book values, which will not be inflated in overbought market conditions. Most importantly, to the value investor, is that companies and their stocks are fairly priced based on their P/B ratios.
An example of a stock with a high, yet justified P/B ratio would be Amazon (AMZN). With a high P/B ratio, this is unlikely to be a company that Warren Buffett invests in. You may be thinking, this is clearly an overbought, overpriced stock! Here is what you have to consider – Amazon has had quarterly revenue growth of about 20% for many years, and continues to expand its operations. This is something that value stocks with beat down P/B ratios lack – they are not high growth. Thus, many stocks have justifiably high P/B ratios when they have growth, or when they have high profit margins. Many of the FAANG stocks will have large P/B ratios, but this should not discourage you from investing in these companies.
Google (GOOG), for example, has a high P/B ratio. Thus, it is not necessarily a Buffett stock, but it surely is cheap for a technology stock. As an investor, I know Google will continue to expand. With profit margins and quarterly revenue growth both above 20%, I may consider purchasing Google at these valuations. Perhaps the strict value investor may not, but the P/B ratio can still give you information about stocks that don’t qualify as traditional value stocks.
The P/B ratio is not the only indicator used to find value stocks. Is there a reason as to why the stock’s price is matching its book value? Perhaps the product or service offered by the company is no longer competitive. In this case, the stock would be a good purchase. This ratio should be used to confirm the intrinsic value of a company, which, like any other trustworthy company, has good management principles, and a forward-thinking expansion strategy. It is one of the most important fundamentals used by the value investor, and one anyone should pay attention to.