There are multiple secrets to being a successful investor. Financial markets are thrilling, and we always see some star investors profiting off their instincts.
But, as exciting as it may sound, it is not always instinct.
These successful investment tactics are a combination of intensive research and systematic analysis combined with a pinch of instinct.
One thing that has always been a constant in the investing practices of these intelligent investors is seeking stocks of undervalued companies. They do it with the help of the PB Ratio. The PB Ratio is not the only factor, but it is undoubtedly essential.
How? Well! Read on to know the details.
PB Ratio helps investors identify whether a stock is undervalued or overvalued. In turn, this Ratio helps the investor invest in stocks whose prices might rise in the future. After finding an undervalued stock, the investors buy it at low prices and wait for them to skyrocket.
As soon as there is a sufficient price rise in these companies’ stock, investors sell them at their desired profit. But, how is PB Ratio capable of identifying stocks? First, we need to understand PB Ratio in detail to answer this question.
The Price to Book Ratio is the proportion of an organisation’s Stock Price to its Book Value per share.
Price to Book Ratio = Market Price per Share / Book Value per Share
Book Value per Share is calculated by dividing net assets by outstanding shares in the company.
where, Net Assets = Total assets – Total Liabilities.
The Market Price per Share represents the current price of the company’s share in the stock market. One can derive the market price by quoting the stock market value of the company through the price charts.
Suppose an organisation named Alliance owns assets of INR 200 crores and has liabilities of INR 150 crores. The share price of Alliance happens to be INR 10 per share.
One more detail is that Alliance possesses outstanding shares worth 20 crores. So, what is the PB ratio of Alliance?
To calculate the PB ratio, we need to know two things. First, the Market Price per Share and second, the Book Value per Share.
We already know the Market Price per Share of the Alliance, and it is INR 10 per share.
Let us calculate the Book Value per Share of the Alliance.
Book Value Per Share = (Total Assets – Total Liabilities) / Number of Outstanding Shares in the company.
Hence, Book Value per Share of Alliance = (200 crores – 150 crores) / 20 crores.
Book Value per Share of Alliance = 50 crores / 20 crores.
Book Value per Share of Alliance = INR 2.5
Now that we know the Market Price and the Book Value, let us determine the PB ratio.
Price to Book Ratio = INR 10 / INR 2.5 = 4
Hence, the PB Ratio of Alliance is 4.
A Price to Book Ratio of value 4 indicates that the company’s Market Value is four times its Book Value.
The ideal PB Ratio is subjective and different for different industries. A PB Ratio of less than 1 is the perfect consideration for any organisation, and it directs you to potentially undervalued companies.
But, in the upper range, a PB Ratio of 3 is considered acceptable. However, companies with higher PB ratios are considered overvalued, and hence they are ruled out by investors looking for value investing.
The best use of PB Ratio is when comparing companies that belong to the same industry, and PB Ratio is ideal for peer to peer comparison.
One crucial shortfall of the PB Ratio is that it is useless in sectors that possess intangibles as their most valuable assets, like the Information and Technology industry.
Investors who are constantly looking for undervalued stocks execute their search with the help of the PB ratio. PB Ratio helps an investor know whether the stock is undervalued or overvalued.
An undervalued stock is an ultimate catch for bullish investors looking to obtain profit by selling these undervalued shares at a higher price when their market value has risen.
The PB ratio aids the identification of undervalued shares depending on the industries. For example, an IT company with a PB ratio below one could indicate an undervalued stock because of the absence of valuable intangible assets from the book value.
Overall, the PB ratio is a good indicator of worthy investments. It follows the method of comparing the book value of a company with its market value, thereby giving us insights into the company’s fundamentals.
PB ratio also facilitates the investors in identifying problems in a company, if any.
Suppose an organisation that belongs to tangible assets heavy industry has a low PB ratio. It might indicate issues in a company because book value accounts for all tangible assets. Hence, if such a company has a low PB ratio, it hints toward internal issues in a company like management problems or ownership arguments.
Given the conflicts, these problems could be the primary reason behind a company’s complete non-disclosure of income because they might be unsure of how to account for them.
Therefore, the PB ratio can save you from potential pitfalls.
We have been well-versed in the importance of the PB Ratio as a metric to gauge the value of a company’s shares. However, there are certain areas where the PB ratio falls short.
The first limitation of the PB ratio is its inability to compare companies from different industries. Industries with a higher intangible asset worth have low PB ratio than industries with more tangible assets. For example, an IT company will have a low PB ratio than an FMCG organisation. But, this does not mean that the IT company is incapable of gaining a high market value.
So, the PB ratio can be deceiving when evaluating companies with ideas, innovation, patents, copyrights and goodwill as their core assets.
Another limitation of the PB ratio is its conservative approach in scenarios like acquisition write-offs or buybacks, and these scenarios tend to deform the book value figures. Hence, while searching for undervalued stock, market savvy investors look at multiple financial tools and the PB Ratio.
The PB Ratio of a lower value helps the investor identify an undervalued stock with an exceptional future earning potential to be a solid investment.
But, a low PB Ratio might not always signal an undervalued stock, but it may signify underlying issues within a business. So, one must evaluate the sectors and peers of a company before banking on the PB Ratio.
This Ratio is also well suited for capital intensive companies. Companies like energy firms that have high tangible assets and their ledgers can be judged perfectly with the help of PB Ratio. Telecom, transport and Oil refining are a few industries that complement PB Ratio. But, it is strictly advisable to execute a peer to peer comparison before investing in these companies.
The PB Ratio fails to incorporate any potential earnings and intangible assets. But, it is efficient to identify companies that have overvalued stock prices without any significant asset value.
Hence, the PB Ratio is an accurate measure for identifying overvalued and undervalued stocks.
But, there is a caveat. One can invest in a high debt company with a high-interest coverage ratio.
However, such companies often overvalue their assets after deducting the depreciation. This practice, in turn, leads to an incorrect PB Ratio, thereby giving a blurry picture of the company’s book value.
The absence of accumulated depreciation in the Balance Sheet is also one of the artificial ways to showcase a high PB Ratio.
Conclusion
In a nutshell, one can say that PB Ratio is a valuable tool for financial analysis, but its usage should be wise. Simply knowing the Ratio is not enough; one must consider various factors before going ahead with their investment.
Market savvy investors use PB Ratio to find the undervalued stock. But, it is not always the undervalued stock with a low PB Ratio. Sometimes, the company may be devoid of earnings due to fundamental problems. Hence, focusing only on the PB Ratio can be risky. Instead, it would be best to consider several parameters for a holistic view.
The net value of an asset on the balance sheet after deducting the accumulated depreciation is known as the Book Value of that asset.
Book Value of a business is the surplus of the total value of tangible assets after deducting the intangible assets, like goodwill or patents, and liabilities.
A PB ratio above three can be a Red flag for companies that belong to industries that require possession of highly valued tangible assets. For companies with a higher value of tangible assets, a high PB ratio suggests overvalued stock.
However, a high PB Ratio is possible for an established IT industry. In this case, the PB Ratio is not a red flag because the majority of the value for the IT industry remains in its intangible assets that are not taken into consideration while calculating PB Ratio.
Book Value is excellent for understanding a company's valuation. When individuals decide to invest in a company, they are making themselves a part of that company. Hence, one needs to be fully aware of a company's operations and net assets before taking part in it.
If things start going south after your investment, it would be a loss deal. This is why Book Value is a good indicator for understanding a company's financial position.
The book value tends to be negative when a business has more liabilities than assets. A negative book value also harms the PB Ratio, and it signifies the weak fundamentals of the companies.
A negative cash flow, long term creditors and long term loans could be the reason behind invalid negative Book Value and weak PB Ratio.
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