The Price to Book Ratio: definition, calculation and backtest

The Price to Book Ratio (P/B ratio) is one of the most widely used fundamental indicators in financial analysis and stock market valuation. This tool allows investors to compare a company's market value to its book value, providing valuable insight into its relative valuation.

Price to Book Ratio: Definition and Importance

The Price to Book Ratio, also known as the price-to-book ratio, represents the ratio between a company's market capitalization and its book value.

This ratio is particularly important because it helps assess whether a stock is overvalued or undervalued relative to its assets. A P/B ratio below 1 suggests that the stock is trading below its book value.

Investors frequently use this indicator to identify investment opportunities, particularly in traditional sectors where tangible assets play a predominant role.

How to calculate P/B ratio

To calculate the P/B ratio, divide the stock price by the book value per share. Book value per share is obtained by dividing shareholders' equity by the number of shares outstanding.

The formula can be written as: P/B = Share price / (Equity / Number of shares).

Interpreting the ratio: high and low values

A high P/B ratio (greater than 3) generally suggests that the market highly values the company's growth prospects or its ability to generate profits.

Conversely, a low ratio (less than 1) may indicate either potential undervaluation or structural problems in the company requiring further analysis.

Interpretation should always take into account the sector context and market conditions. Some sectors, such as technology, traditionally display higher P/B ratios.

Advantages and limitations of Price to Book on the stock market

The main advantage of the P/B ratio is its simplicity of calculation and its ability to quickly provide an indication of the relative valuation of a company. The P/B also allows one to assess the valuation of a company that is making losses, which is not possible with the Price/Earnings (PE) ratio.

However, some companies may use creative accounting techniques to embellish their balance sheet, such as overstating certain assets or understating liabilities. This can lead to a distortion of the P/B, making certain accounting values unreliable.

Moreover, in the digital economy, it is becoming more difficult to interpret the P/B ratio. Technology and digital companies often have valuations that are significantly higher than their book value due to the intangible nature of their assets, such as intellectual capital and intellectual property. In this context, a high P/B ratio can be justified by exceptional growth prospects and innovative business models. However, investors should be cautious, as a high P/B ratio can also signal an increased risk of a value correction if growth expectations do not materialize.

Backtest

To assess the effectiveness of this ratio on the Swiss and French markets, I performed a backtest extending from 2004 to 2024. Stocks were ranked according to their P/B and divided into quintiles. I used book value data from the most recent half-year. The process was repeated each year during the observation period, allowing an analysis of the performance of each quintile.

The results have been adjusted to take into account dividends, fractional shares and other corporate events that may influence stock value.

The P/B performed slightly better in the backtest within the overall market for the French market and within the economic sectors for Switzerland. Below I will only present the results obtained with the best method for each market.

Backtest results (average annual performance in CHF)

• in Switzerland, best quintile (comparison within economic sectors): 9,04% (market 8,36%)
• in France, best quintile (overall market): 4.52% (market 3.06%)

By company size

Whether in Switzerland or in France, the distinction based on company size does not work very well for this indicator.

Lessons from the backtest

• P/B works in both markets analyzed. Top-ranked stocks beat the market.
• Even if the results are less good in France, because of a market lagging behind Switzerland, the P/B brings greater added value there.

There gross margin growth (comparison within industries) is still the best performing single ratio we have studied so far in Switzerland (13.4% per year for the best quintile). In France, it's still dividend yield (within the industries) which performs best on the whole market with 7%/year.

Conclusion

Although it has seen some decline in popularity in recent years, the Price to Book Ratio remains a valuable tool in financial analysis. It offers investors the opportunity to outperform the market, even if this effect is relatively limited over the period studied.

In the digital age, book value is likely to have lost its importance in valuing a company. However, it is important to be wary of changing trends. In a few years, tangible assets may regain their place at the heart of investors' concerns, to the detriment of intangible assets.