Investment Banking: How to Calculate the Price-to-Book Ratio
Price-to-earnings is a popular measure, but an imperfect one. The P/E ratio can tell investment bankers what investors are willing to pay for a dollar of earnings. A company’s earnings, while important, are just one dimension of its value. Another measure, one that’s closely watched by investors who are looking for bargains and investment bankers alike, is book value.
Book value is the corporate equivalent of a person’s net worth. Investment bankers often focus on tangible book value, because it strips out assets that may be hard to accurately value or quickly sell. A company’s tangible book value is its tangible assets minus its liabilities.
The price-to-book ratio is the company’s stock price divided by book value. The ratio tells investment bankers how much investors are paying for every dollar the company would raise if it were, in theory, liquidated and book value could be realized for the assets and liabilities.
In some situations, the price-to-book is preferable to P/E:
When dealing with a young company: When companies are just starting out, they may have diminutive levels of earnings or even losses. In cases like these, the P/E ratio may be ridiculously high or not even meaningful.
When a cyclical company is in a downturn: Earnings of some companies rise and fall by large degrees along with the ups and downs of the economy. During periods of economic decline, a company’s P/E may look artificially high if the stock price hasn’t fallen by as much as earnings. This can give a misleading impression of valuation.
When dealing with a capital-intensive business: In some industries, massive investments in plant, property, and equipment are required. These firms may make enormous investments that are more significant to the value of the company.