Investing Series: Ratios – Price to Book P/B Calculation

This is a part of the Investing Series.

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In short, this is just the share price in comparison to the book or fair value of the company.

• Read: What is a book or fair value of a company?

HOW TO CALCULATE PRICE TO BOOK OR P/B

Before we do this, you need to know how to calculate “Book Value”.

As I mentioned before, you can just go to any site like Yahoo or Google Finance and look at the P/B ratios without doing the work, but I’m a firm believer in knowing what goes behind these things.

You should KNOW how things work.

THERE ARE TWO TYPES OF CALCULATIONS

You can decide to calculate the share price to include physical assets ONLY, or both physical and intangible assets.

It gets unwieldy.

I prefer to rename these things in my head, and I personally call it:

1. Price to Book Value = Tangible assets only
2. Price to Fair Value = Tangible and Intangible assets only

• Read: What’s the difference between Market Value, Book Value and Fair Value?

Obviously my re-naming is not officially accepted by anyone but myself, but it helps me keep things straight in my head.

Otherwise, you have to keep saying: Price to Book, and then you have to clarify what “book” means.

Does it mean tangible assets only?

Or all their assets?

It’s just easier for me just to give it another name in my head to keep it straight.

HOW TO CALCULATE PRICE TO BOOK VALUE

(Also called “Price to ‘Tangible Book'”)

First, you calculate Book  Value like this:

Total Assets – Intangible Assets – Liabilities = Book Value

The “book” value is what can be physically sold at auction like the land, or the furniture of a factory (tangible assets).

The “fair” or total value of a company, includes things like their reputation (intangible assets), which people try to put a fair market value on, because it has some cachet.

• Read: What’s the difference between Market, Book and Fair Value?

Then…

You calculate P/B like this:

Market Price / Book Value

Market Price: What it’s trading at today on the stock market (also called “stock price”)

Book Value: What the company owns as physical assets.

HOW TO CALCULATE PRICE TO FAIR VALUE

Now if you want to add in intangible assets like patents and goodwill, you do it like this:

Total Assets – Liabilities = Fair Value

Then…

You calculate Price to Fair Value like this:

Market Price / Fair Value

Market Price: What it’s trading at today on the stock market (also called “stock price”)

Fair Value: What the company owns as assets both physical and intangible.

NOW HOW DO I ANALYZE THE RATIO OR NUMBER I GET?

Depending on what your investing strategy is, you can choose to look at P/B in a couple of ways.

• Less than 1 = The stock is trading BELOW the company’s tangible assets or book value
• 1 = The stock is trading exactly at what it is worth in terms of tangible assets or book value
• More than 1 = The stock is trading above what it’s worth in tangible assets or book value

If you think about it, it makes sense.

A SUPER CHEAP STOCK TRADING BELOW BOOK VALUE

People who look for ‘value’ stocks, tend to look for a P/B ratio that is low.

This is a P/B value of BELOW “1”.

That is, they want to buy the stock that’s CHEAPER than what the company is really worth on paper (in terms of its assets, both tangible and intangible).

Think of it like hunting for a sale, or getting a discount.

A company that has $9 worth of assets to its name as its net worth, is trading at $8 a share on the market, just means that if you were to break apart that company and sell off its parts TODAY, you would get $9 instead of the $8 you paid.

A FAIR VALUE FOR A STOCK TRADING AT PAR / EQUAL TO BOOK VALUE

People who want to pay what a stock is worth, look for the at-par value of a stock.

This is a P/B value of “1”.

That is, what it is worth, is what it is really worth.

A company that has $9 worth of assets to its name as its net worth or book value, trading at $9 a share on the market is ‘at par’ or equal to book value.

A STOCK THAT HAS A POTENTIAL TO GROW

So after reading the above, why the heck would anyone pay more money for a stock?

It’s because some stocks trade ABOVE a P/B value of “1” because it has potential to grow and make more money.

Take Starbucks for instance, their P/B value is about 8.32, which means it is trading at 8.32 times HIGHER than what the company is worth on paper.

The stock being at around $57 today, it means on paper its book value is really about $6.85.

If you were to break apart Starbucks today, if you paid $57 for their stock, you’d only get $6.85 back for what you paid.

Sounds ridiculous right?

They trade at more than what their parts are worth!!

So are they over-valued by the market?

Not necessarily.

(Depending on who you ask, that is.)

That’s because their cachet and name for being the ‘IT’ coffee drink that all the cool Westerners, movie stars, singers and celebrities drink, allows the brand to have a high potential to grow and take over non-Western markets full of people who want to emulate their idols.

That premium of cool (much like a brand name), is worth $50.15 MORE to investors, because they’re buying a company that has a reputation and a brand name that is expanding to become globally recognized.

There’s a potential there that investors believe in and they’re paying a premium for it.

SUMMARY

• Price to Book Value can be calculated taking tangible assets only, or intangible ones too
• Personally, Price to Book Value for me means Tangible Assets only
• …and Price to Fair Value for me means Tangible and Intangible Assets included
• Ratios of 1 or lower, mean that the company is trading below what it’s worth on paper
• Ratios of 1 or higher, mean the company is trading above what it’s worth on paper
• People pay more than what it’s worth for something, because there’s potential