The price to book ratio compares the current market price of a company's stock to its aggregate book value. When the ratio is excessively high, it can indicate that a company's shares are over-priced, especially when the ratio is high in comparison to the same calculation for other companies in the same industry. The calculation is:
Investors like to use the price to book ratio to search for undervalued companies, and invest in their stock in hopes of having the share price return to a more normal level over time. However, there are a number of issues with the ratio to be aware of, including the following:
- The ratio could be low because the company has been mismanaged, in which case there can be no expectation that the ratio will improve over time.
- The ratio could skewed too high because the company is using accelerated depreciation to write down the value of its fixed assets at an accelerated rate.
- The company may have valuable intellectual property that does not appear on its balance sheet at all, but which is being recognized by investors through a high market price for its stock.
- The company may be investing a large amount in research and development costs, which must be charged to expense as incurred, rather than capitalized. This tends to result in a comparatively low book value for the business.
- The ratio is not overly useful when evaluating services firms and technology companies, since these entities have comparatively fewer fixed assets on their balance sheets.