In stock markets, investors use a range of methods to calculate the risk of a stock before investing. One of the basic methods is to evaluate a stock with a price to book value ratio. Also called ‘fundamental analysis’, it aims to show the investor the true current value of the company (Sharafoddi and Emsia, 2016). Valuation of a stock is the process of determining the intrinsic value of a company’s stock. It is an estimate of a stock’s true worth based on the company’s financial and economic indicators, such as earnings, revenue, assets, and growth prospects.
A common way of estimating the valuation of a stock is by using financial ratios. They are used by investors to compare companies’ performance and predict future stock prices (Baresa, Bogdan and Ivanovic, 2012).
There are different financial ratios that indicate a company’s health. Some of them are:
- Price-to-Earnings (P/E) Ratio: This compares a company’s stock price to its earnings per share.
- Price-to-Book (P/B) Ratio: This compares a company’s stock price to its book value (total assets minus liabilities).
- Relative Valuation: This method is used to value a stock based on the comparison of different financial metrics, such as P/E, P/B and Price-to-Sales (P/S) ratios, of companies in the same industry or sector.
Financial ratios can indicate overvaluation and undervaluation of the stock
Undervaluation and overvaluation is an essential part of behavioural economics because of the profound impact it has on investors’ sentiment and decision-making. Overvaluation occurs when the market price or the stock price is higher than its fundamental value. On the other hand, undervaluation is when the stock price is lower than its fundamental value (Mishra and Kumar, 2016). In both cases, the stock is misvalued, which makes it a high-risk instrument (Dong, Hirshleifer and Teoh, 2012).
Role of price to book value (P/BV) ratio in stock valuation
Price-to-book value ratio (P/BV) is one of the key indicators of a stock’s true value (Pysh, 2020). The price-to-book ratio is a financial ratio that compares a company’s market value (stock price) to its book value i.e the value of its assets as reported on the balance sheet.
It is calculated by dividing the current market price of a stock by its book value per share (Fernando, 2022). A low P/BV ratio suggests that a stock is undervalued and may be a good buying opportunity. While a high P/BV ratio suggests that a stock is overvalued and may be overpriced. A P/BV ratio of 1 indicates that the stock is trading at its book value. Therefore, a low P/BV ratio is often favoured by investors.
According to billionaire investor Warren Buffet, the threshold P/BV ratio for investors should be 1.2, i.e., an investor should purchase a stock of a company only when its P/BV ratio is less than 1.2 (CNBC, 2018). Recently, however, he has loosened this policy and even enlisted 7 situations in which an investor can make exceptions while investing in a stock with a high P/BV ratio.
Evaluating a stock by calculating the price-to-book value (P/BV) ratio
Suppose an investor plans to buy shares of Roadside Supermarts and its closing price on Jan 10th 2023 was Rs 3878. Its total assets till Mar 22 are Rs 154726400000 (Rs. 15,472.64 crores), total liabilities are Rs 17947500000 (1,794.75 crores), and shares outstanding are 647770000 (64 crores). He is expecting a stable market with not much change in share price till February.
In order to calculate the P/BV ratio, the investor will first calculate the Book Value per share. For this, the two main variables are total assets and total liabilities. This data can be obtained from the company’s financial statements publicly available on sources like Moneycontrol and Economictimes.
The current share price is Rs. 3878.
So, the investor will receive Rs 211.15 per share by paying Rs 3878, when the company goes bankrupt.
Once the book value per share is computed, the price-to-book value ratio will be calculated (Fernando, 2022).
So the current price to book value is 18.37, which is way more than Warren Buffet’s recommendation of 1.3. this means that Avenue Supermarket stock is currently overvalued. There is the possibility of a fall in prices in the future and loss thus, the investor should avoid Roadside supermarkets.
Furthermore, suppose in February 2023 the market condition does not go as the investor expected. Instead of a stable market, the price of stocks has decreased and now the share price is Rs 2000. Should the investor invest in it?
|Book value per share||211.15||211.15|
Keeping all other values the same, the new price-to-book value ratio is 9.47.
Since the P/BV ratio is still way above 1.3, the investor should still avoid it. Suppose the stock kept falling and in June 2023 it fell to an all-time low of Rs 250. Now the P/BV is 1.18, i.e., less than 1.2. since the stock is now undervalued, the investor should invest in it.
Warren Buffett’s 7 principles to buy an overvalued stock and exceptions
Warren Buffett has held his principle of investing in a stock only if its P/BV ratio is less than 1.2 for a long time. He also has 7 golden rules of investing (Bayer, 2020):
- Check the company’s intrinsic value and avoid making any decisions based on emotions only.
- It’s better to buy quality shares at a fair price than a fair company at a wonderful price.
- Never invest in stocks of companies that you don’t understand.
- Don’t miss any big opportunities.
- Don’t just sell shares due to price fluctuations.
- Buy shares at the prices which they are worthy of.
- Be fearful when everyone is greedy while greedy in the case when everyone is fearful.
These rules thus broaden the perspective of investors as the decision should not be just based on book values but also on the past performance of the company.
Continuing the above case of Roadside Supermarts, suppose in January 2024, the stock price rises to Rs. 6000. This means that Roadside Supermarts in the past 5 years had a yearly growth rate of 28.5%. With this the new price-to-book value ratio could be stated as:
|Book value per share||211.15||211.15|
The new price-to-book value ratio has increased to the level of 28.42 from 18.37.
Now over the last year, the investor has dabbled in many retail stocks and knows the market better than last year. In this case, the investor should invest in Avenue Supermarket’s stock even though it is overvalued because he would be fulfilling two of Warren Buffet’s 7 rules of investing:
- Due to its constant year-on-year growth, this stock can provide an opportunity to multiply capital.
- The investor understands the market well.
Therefore, under this condition, the investor should grab the opportunity of investing in this stock.
So, as a new investor, the investor should adopt the conventional approach and invest in the stock only if its P/BV ratio matches that of Warren Buffet’s principle.
However, if the investor has a good idea about the market and the stock performs well continuously for a period of over five years, he can take a calculated risk of investing in it.
The price to book value (P/BV) ratio is a good indicator of a company’s management efficiency and the overall health of the company. It also helps to compare a company’s performance to that of its industry peers or to the market to get a better sense of the stock’s relative value. When the P/BV ratio is high, it shows that a company’s stock is overvalued and that an investor should not buy it.
However, when a company’s fundamentals, such as its earnings and revenue growth, suggest that the stock is likely to continue to appreciate despite its current high valuation. In this case, the stock’s future growth justifies its current high price.
- Baresa, S., Bogdan, S. and Ivanovic, Z. (2012) ‘STRATEGY OF STOCK VALUATION BY FUNDAMENTAL ANALYSIS’, UTMS Journal of Economics, 4(1), pp. 45–51.
- Bayer, B. E. (2020) 7 Investing Lessons You Can Learn From Warren Buffett, The Motley Fool.
- CNBC (2018) ‘Berkshire Hathaway shares jump after Warren Buffett loosens policy on stock buybacks’, CNBC, 18 July. Available at: https://www.cnbc.com/2018/07/18/buffetts-berkshire-hathaway-loosens-policy-on-stock-buybacks.html.
- Dong, M., Hirshleifer, D. and Teoh, S. H. (2012) ‘Overvalued Equity and Financing Decisions’, The Review of Financial Studies, 25(12).
- Fernando, J. (2022) No TiPrice-to-Book (PB) Ratio: Meaning, Formula, and Exampletle, Investopedia.
- Mishra, S. and Kumar, R. (2016) ‘Investigation of overvalued and undervalued stocks: the case of BSE Sensex’, International Journal of Business Excellence, 10(2).
- Pysh, P. (2020) Warren Buffett Investment basics, The Investor’s Podcast.
- Sharafoddi, S. and Emsia, E. (2016) ‘The Effect of Stock Valuation on the Company’s Management’, Procedia Economics and Finance, 36, pp. 128–136.