The Price to Book Value or PBV is one of the numerous stock market ratios that are used in the fundamental analysis to try to determine if a company is cheap or expensive and for that it measures the current market price of the company with the book value of it.
How is PBV calculated?
The market capitalization of the company is divided by the book value of the company on the balance sheet, which is nothing else than its own funds.
P/B = (number of shares * listed on the stock exchange) / own funds
How easy is not it?
You are right.
This is one of the most popular ratios of the stock market with the same Warren Buffet and other legendary analysts of the stock market always considering it among their arsenal of tools to study.
The ratio is associated with value investing so there are many scholars who try to apply it to obtain advantages in order to invest in the stock market.
Is a high or low P/B value better?
Obviously if the value comes out very high, it would be logical to think that the price of the stock is overvalued.
But overrated according to what?
As in the rest of the cases of the fundamental analysis, it is about comparing this ratio between shares of the same sector, and also see the evolution of the same over the years, trying to see what value it had in the bull markets and in the soils of the bear markets, when fear reigned.
Well, supposedly we are going to be interested in investing in companies with a low P/B because it would be telling us that the price is not too high relatively with the book value of it.
In that way it would seem logical that we do not buy companies with a P/B too high, since the same could be a sign that the company is overheated.
For example, in the last 12 years, Apple has been very few times above the level of 8.
One was in December 2007, and another is now, in mid-2018.
Given the history, it is likely that we will not find ourselves in the best moment to invest in this stock right now.
However, moments in which the P / B was below 3, were 2009 and 2013, after the price of that share fell substantially.
Those two moments were good to buy Apple in the long term, no doubt.
However, in this type of stocks the thing can be very confusing because they can spend many years with relatively high levels, above 4, in which the price does not stop rising, as almost the entire stretch of 2009 to 2012.
So we can see that there is no magic formula of happiness with the price / book value ratio.
The thing does not work so easily.
The only thing we can make clear, more or less, is that when the thing is in extremes, as in the example of Apple, it is usually a good sign of “overbought” or “oversold”, and therefore we can have good value signals.
In the rest of the cases, those intermediates, things are not so clear.
Interpretation of P/b Price to book ratio
- When it is less than 1. The quoted price is very low for what we are supposed to buy, but beware, because here we can have a case of a company that is on the way to bankruptcy, something that happens on many occasions.
- Around 1. It is also assumed that the company is “cheap” here, but we would have to see the circumstances, such as general market, particular sector, evolution, and etcetera.
- Greater than 1. This case is the most normal and the one that we will see in the vast majority of cases, as we discussed with Apple, which has never dropped from 2 in the last decades.
The problem when applying the P/B ratio
As I said when we say that when we have values close to one, it can mean that the stock is about to break or on very muddy ground, we can see many cases like when PB fell below 1, it was a disaster to buy in order to invest long-term.
Imagine that you have a system to invest in stocks whose P/B is lower than 1.
Well, in 2007 and 2008 many actions did.
Many of which are still trading very far from when their price was at the time of crossing the P/B below 1.
For example Citigroup
The Citigroup P/B ratio was above 1 during 2007 but at the beginning of 2008 it fell below that value when the price was at 200 dollars.
Ten years later it quotes at 69 dollars.
Another classic case of those years: AIG
This colossus of American finance was trading at $ 650 in 2008 when its P/B went to 1.
Ten years later it quote is at 52 dollars.
And that I have put a couple of examples of companies that did not go bankrupt.
Imagine what happened to those who invested in Lehman Brothers or Bearn Stearns when the P/B fell below 1?
We can clearly see that trying to invest with P/B can give us horrible signals when an action is on the way to bankruptcy.
The good news is that this case is not the one that always happens and in many cases it happens that we succeed with investments that multiply later with the years.
What we have to be clear about is that beating the market using this indicator is not easy.
Example of Sears
In 2008, the former component of the Dow Jones, Sears, also fell from the level of 1 in the P / B, when it was trading at 80.
Well, to the bad luck of those who invested in it, thinking it was the bargain of the century, the price 10 years later is just over one dollar.
However, the Amazon example is different
The minimum value of the P/B for the last 12 years was approximately 8, in 2008 and 2010.
In 2008 the price was at 51. Ten years later it is at 1950.
It is not that we can compare both companies, but let’s not forget that both groups are engaged in retail, only in different ways.
However, the difference between one and the other is overwhelming.
The truth is that looking at the cases of Amazon and Apple, we might think that it is not as easy as trying to catch stocks that fall below 1 in P/B, because as we saw, these giants have not reached those values, even with crises like the one in 2008
We may have to look for other approaches to invest with this ratio with a somewhat more dynamic approach, obviously.
Assumed better use of the P/B ratio
According to many experts, this ratio works better with companies that have strong assets such as financial institutions, industrial companies and other companies that are highly capital intensive.
That’s what they say a lot in several articles on serious sites.
However, I refer to the given examples: AIG, Bearn, Citigroup; or Deutsche Bank type companies, or any Greek bank before the collapse.
Also, does it work well in what way?
Applying what criteria?
Buying below 1, 2, 3?
Adding other ratios type ROE, or PER?
That already changes the question, but still, believe me, you’re going to have to spin very thin and apply quite complex analysis to try to scratch something.
Regards and good trading.