Price-to-Book Ratio

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The book value of a common stock is found by dividing the net worth of a company by the number of outstanding shares. While there exist several different methods for calculating net worth, the most simplistic involves subtracting total liabilities from total assets, giving us the shareholder's equity figure.

Investment professionals often see the book value as a "floor" for common stock prices, and the price-to-book ratio is quite popular in the field of investment management. The calculation of the price-to-book ratio involves the following equation:

Price-to-book ratio = {P0 / (Net worth / # of common shares outstanding)}

In this example, all of the necessary information has been provided. Imputing these figures into the priceto-book value equation will yield the following:

Price-to-book value = {$20.30 / ($15,381,000 / 1,200,000)} = 1.584.

As you can see, the required rate of return, along with the expected growth rate, is not necessary in the calculation of the price-to-book ratio.

Any time the price-to-book ratio is greater than one, a stock is said to be "trading at a premium to book." Frequently, investment professionals will use the term

"intrinsic value" when referring to the book value. A figure of less than one for the price-to-book ratio is commonly referred to as "trading at a discount to book."

Stocks trading below book value are often sought after by value investors, who believe these shares have been discounted below their liquidation value.

While the price-to-book value is a useful tool in the stock selection process, it possesses some important flaws. One problem with the Price-To-Book Ratio is that one of the terms - Book Value - is so easily manipulated. Valuation of inventory and real estate are easily adjusted on the books. Stock buy-backs and write-offs of exceptional items also deflate Book Value, making high priced stocks seem overvalued.