Something Else for Your Toolkit: Price-to-Book Ratio

I've spoken in this space about the price-to-sales ratio, generally considered a better way of valuing smaller companies without earnings or with wildly high P/E ratios. Actually, price-to-sales isn't a bad way to value any company, because earnings are easily manipulated (see the June 13 column about 40 ways to embezzle). Another method of evaluation to have in your tool kit is the price-to-book ratio, or P/B, simple but much-used by the likes of business-development companies and others who like to directly invest in or better yet, acquire companies.

Price to book is the current price of the stock divided by the book value per share, the book value being the equity-liquidating value per share, or more simply, total tangible assets minus total liabilities -- how much you'd get if you auctioned off the company now. Investors who buy stocks with low price-to-book ratios believe they're getting the stock at a price close to the liquidating value, and that they'll be rewarded for not paying too much for what would be left if the company went bankrupt this afternoon. P/B ratios are commonly used to compare banks because most assets and liabilities of banks are constantly valued at market values.

A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware that P/B varies by industry. Industries that require more infrastructure capital (for each dollar of profit) will usually trade at P/B ratios much lower than those of, say, consulting firms. Unlike P/E, though, P/B does not provide any information on the ability of the firm to generate profits.