The P/B ratio compares a stock's market price with its book value. (Book value is the equity balance an a firm's balance sheet divided by the number of shares outstanding.) Conservative investors often prefer the P/B ratio, because it offers a more tangible measure of a company's value than earnings do. Legendary investor Benjamin Graham, one of Warren Buffett's mentors, was a big advocate of book value and P/B in valuing stocks. (See Lesson 504 for more on Ben Graham.)
There are caveats to using P/B, just as there are for all the other simple ratios we will discuss. The carrying value of an asset on a company's balance sheet may not reflect the true value of the asset. For example, a future charge to write down the value of an overvalued asset could dramatically reduce a firm's book value and change the P/B in one swipe. On the other side of the coin, the book value of a company doesn't always accurately measure its true worth, especially for firms with lots of intangible assets such as patents, databases, and brand names that don't show up on the balance sheet. Some assets, like land, are also carried on a company's books at cost. If a company has held a property for a long time, chances are the value of the land is much greater than what its books state.
The P/B ratio is also tied to return on equity (remember, ROE is equal to net income divided by average book value) in the same way that price/sales is tied to net margin (equal to net income divided by sales). Taking two companies that are otherwise equal, the one with a higher ROE will have a higher P/B ratio.
The reason is clear--a firm that can compound book equity at a much higher rate is worth far more because absolute book value will increase more quickly.
Price/Earnings (P/E) >>