Today we’re answering the question, what is a good price to book ratio? This is near impossible to have a one-size-fits-all approach. However, for me personally, I use the following guidelines.
For a growth stock, I look for a price to book below 7
For a value stock, I look for a price to book below 3
The above is not to say that a price to book higher is necessarily bad. But it alerts to me that I need to really dig in and understand why.
Let’s break this down.
What is a Price to Book Ratio
A price to book ratio, or PB, is equal to the following:
PB = Share Price / Book Value of Equity Per Share; or
PB = Market Capitalization / Book Value of Equity.
where:
Book Value of Equity = Total Assets minus Total Liabilities.
What it tells you is how much of a premium a share trades at to the actual book value of what common stockholders own.
Put another way – a company has $1m in assets and $500k in liabilities. Therefore, there is $500k in equity. Presumably, if the company was liquidated and everything was liquidated at book value, shareholders would receive $500k pro-rata.
Interpreting a Price to Book Ratio
When interpreting a price to book ratio, you need quite a bit of context.
You may be thinking, why would you ever purchase a company above its book value? The answer is two-fold.
First, you are ignoring future growth. In the above example, $500k in equity in a company that grows at 2% a year is quite different from a company growing at 20% per year. This is why growth stocks tend to trade at higher PB ratios.
Second, there can be significant accounting differences between company that over-inflate, or under-inflate, the book value of equity. The biggest example is around goodwill/acquired intangible property on the balance sheet, versus internally developed intangible property that is not accounted for as an asset.
In the latter case, shareholder equity may be inflated when comparing to a company that developed everything internally. Remember, all else equal, more assets equals more equity.
All in all – you need to do more due diligence than just read a price to book ratio. You must understand WHY a price to book ratio is what it is versus its competitors.
What is a Good Price to Book Ratio?
You can probably tell by now that, all else equal, a lower price to book ratio is better than a higher price to book ratio. But, like I said, we need context.
Because of that, I’ve broken down my ideal price to book ratios for growth stocks and value stocks.
Growth Stocks
For a growth stock, I look for a price to book below 7. Why is that?
As of writing this post, QQQ, which tracks the NASDAQ, trades at a price to book ratio of around 7. The NASDAQ is heavily concentrated with growth stocks and gives us some insight into how broader growth stocks trade.
Therefore, if a company is trading above QQQ’s price to book ratio, I need to understand why. It could mean that it is overvalued, or there could be another reason.
Value Stocks
For a value stock, I look for a price to book below 3.
Value stocks, conversely, tend to trade at lower price to book ratios. These stocks generally are lower growth stocks, but make up for it with strong profits and cash flow.
In other words, you are investing more for TODAY’s earnings, rather than tomorrow’s potential earnings.
As of writing this article, most value indexes of large cap stocks trade somewhere between a 2-3 price to book. Therefore, if a company is trading higher than that, I want to dig into it and understand why.
Bottom Line
So there you have it! A price to book ratio is a tricky metric and needs a lot of context. But if you can dig through the muck and understand what’s going on, you can glean some great insight.
To summarize then, here’s what I’m broadly looking for in terms of what is a good price to book ratio.
For a growth stock, I look for a price to book below 7
For a value stock, I look for a price to book below 3
DISCLAIMER – THIS ARTICLE IS NOT FINANCIAL ADVICE. THIS ARTICLE DOES NOT CONSTITUTE A BUY, SELL, OR HOLD RECOMMENDATION ON ANY SECURITY MENTIONED HERE. THIS ARTICLE CONSTITUTES MY OPINION AND NOT A STATEMENT OF FACT. ALL INFORMATION REGARDING THE FINANCIAL SECURITIES MENTIONED IS ACCURATE AS OF JANUARY 23, 2024. DO YOUR OWN RESEARCH.