A firm’s market-to-book ratio is a measure of its market value relative to its book value. Sometimes, it is called the price-to-book ratio, where the book value is equal to the accounting value of the firm.
In Warren Buffett’s annual Berkshire Hathaway shareholder letters, he has reported book value each year despite admitting that it is not perfect in determining the value of a firm.
Buffett describes the measure as a “crude but useful tracking device for the number that really counts: intrinsic business value.”
It is generally easier to track book value for asset-rich companies, such as industrial companies that make equipment, railway companies, and manufacturers with tangible assets. Banks and insurance companies also make good candidates to track book value because of the steady inflow of assets.
Where book value runs into trouble as an accurate measure is that not all companies follow the same accounting practices. A manufacturer may spend a lot of money buying equipment that has lower re-sale value in the real world than is reflected on the books when factoring in depreciation. So, it may seem as if the company is more valuable than it is in reality, creating a value trap for investors.
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How Is The Market-To-Book Ratio Calculated?
The market-to-book ratio is calculated as the market value of the firm divided by the book value.
Market-to-book Ratio = Market Capitalization ÷ Book Value
The market capitalization of a firm is set by the public share markets, and depends on the price per share of the stock and the # of shares outstanding.
Market Capitalization = Share Price × Total # Shares Outstanding
The book value of a firm is the net asset value of the firm. Theoretically, it is the sum of every single thing a company owns (including desktop staplers!) and owes.
In practice, the book value is calculated as the sum of a company’s assets that are easily quantified, such as property, inventory, equipment, and financial assets, including cash, stocks, and bonds minus the sum of its liabilities.
The book value of a firm is calculated using the formula:
Book Value = ∑Assets − ∑Liabilities
To more accurately approximate the book value, the balance sheet will include the accumulated depreciation of assets.
Sometimes, the market-to-book ratio (M/B) is displayed on a per share basis:
Market-to-book Ratio = Share Price ÷ Book Value Per Share
What Is A Good Market-To-Book Ratio?
The purpose of calculating a market-to-book ratio is to figure out whether the stock is undervalued, and therefore a good investment, or overvalued and perhaps a good short stock candidate.
Usually the market capitalization will be greater than the book value. However, when the market capitalization of a company is less than its book value, the ratio is less than 1.
During periods of economic recession or stock market turmoil, market-to-book ratios can sometimes drop below one, even on fundamentally strong companies, and these temporary dips can create significant opportunities for value investors.
|<1||Company may be undervalued|
|1 → 3||Company may be attractive to value investors|
|>3||Company may be fairly valued or overvalued|
Without getting into the nitty gritty, the general rule of thumb is that if a company has a return on equity higher than its cost of equity, the market-to-book ratio will be greater than one.
>> Related: What Are The Best Value Stocks?
Market-To-Book Ratio Shortcomings
The reason investors generally avoid using market-to-book ratios as a standalone measure when making valuation decisions is that a very low market-to-book ratio could signify that a company is in serious difficulty.
If a market-to-book ratio is less than one, the company may be undervalued but equally it may be that the market is discounting very poor future earnings.
Book value can also misrepresent the true value of a company when acquisitions have been made, share buybacks have taken place, or assets have been written down.
It also fails to account for intangible assets, such as the value of a company’s brand or its patents and intellectual property rights.
Technology companies like Alphabet or Facebook are generally poor candidates to use market-to-book ratios to gauge valuation because the cost to develop software is low relative to the value generated.
Just because these companies may have high market-to-book ratios doesn’t mean that they are necessarily overvalued.
How To Use Market-To-Book Ratios
One of the best ways to use market-to-book ratios is to compare companies in the same sector or industry.
If most companies have a market-to-book ratio of 4 but a single company is trading at a ratio of 12, it may be overvalued. However, a high ratio may be a result of stellar earnings growth expectations too.
Value investors often look for companies that have a growing book values over time because share prices generally increase when a company’s intrinsic value rises.
Some industries will have lower market-to-book ratios than others. Insurance companies typically have lower ratios than technology companies because when disaster strikes, like a hurricane, the insurance companies need to pick up large yet infrequent bills.
During these times, customer claims increase significantly and these in turn reduce the book value of the insurance companies.