Table of Contents
- 1 What is Market to Book Ratio (M/B)?
- 2 What is Market Value and Book Value?
- 3 Calculate using Formula
- 4 Example
- 5 Analysis & Interpretation
- 6 Limitations
- 7 Uses
- 8 Price to Book Ratio
What is Market to Book Ratio (M/B)?
Market to book ratio is just a comparison of market value with the book value of the firm. In other words, it suggests how much investors are paying against each dollar of book value in the balance sheet. Also known as price to book value, this ratio tries to establish a relationship between the book values expressed in the balance sheet and the actual market price of the stock. Arithmetically, it is the ratio of market value to book value.
What is Market Value and Book Value?
Market value is the value derived by multiplying stock price by the number of outstanding shares. In simple words, we can call it market capitalization also. On the other side, book value is a value derived from the latest available balance sheet of a company. It is as good as the net asset value of a company and that can simply be ascertained by taking all the assets less depreciation and liabilities.
Calculate using Formula
The market to book value ratio can simply be calculated by using the following formula
Market to Book Ratio Formula
Market price per share/book value per share
Market capitalization / book value
Any of the above formulae can be used for calculating the ratio. The first formula needs per share information whereas the second one needs the total values of the elements.
How to calculate the Book Values and Market Values for the Formula?
For calculating book values for the purpose of deriving this ratio, an investor can use the following formula:
Book Value = Total Assets – Total Liabilities – Preferred Stock – Intangible Assets
or Book Value = Shareholder’s Equity (Broadly, Equity Share Capital + Reserves and Surpluses)
Market Value = Market Price per share * No. of Equity Shares Outstanding.
Assume there is a company X whose publicly traded stock price is $20 and it has 100,000 outstanding equity shares. The book value of the company is 1,500,000.
Market to book value ratio = 20* 1 00 000 / 1,500,000 = 2,000,000/1,500,000 = 1.33
Here, the market perceives a market value of 1.33 times of book value to company X.
Analysis & Interpretation
It is important to understand the market to book value ratio when it is less than 1 and greater than 1. If we simply analyze, it can reflect undervaluation when it is less than 1 and overvaluation when it is greater than 1. Let’s check below for the in-depth understanding and interpretation of the ratio.
Market to Book Ratio Less Than 1
Undervaluation – An Investment Opportunity
A normal investor would look at it as an investment opportunity. The basic assumption behind that is “most businesses have higher market value compared to their book values. For a majority, the assumption is true also. The reason is simple. The books of accounts record assets at their purchase price. A business having purchased an asset say a land or building 20 years back, must have much higher market realizable values due to appreciation in real estate prices. In the balance sheet, the balance is shown at the purchase price and therefore the book value does not stand near to the real fair market value of the business. Apart from these, there are intangible assets that the business has created over the course of time. Most businesses have not valued them in their books.
Overvaluation – Misrepresented Books
If we drill deep down, a ratio less than 1 means the market does not even perceive value equals to book value. In a not so good investment scenario, an investor could smell some problem with the corporation. He may think that the value of assets presented in the balance sheet may not be realizable in the open market in case of liquidation. Say, in case of liquidation, selling off the assets will not realize value equals to book value of the company. This may generally happen when some technologies obsolete. A machine whose technology is no more useful in the market will seldom find any buyer. Books may have any purchase value assigned to it.
Market to Book Ratio Greater Than 1
Overvaluation – Book Values are Dynamic
In general, M/B greater than 1, you can interpret overvaluation but only and only when the book values are dynamic. By this, we mean book value inculcate in it the true fair market values of all the assets and has included the values for intangible assets etc.
Undervaluation – Book Values just an Accounting Figure
We would not recommend using only this ratio to judge the overvaluation of the business. Following are the reasons which take away the reliability of book values for any major analysis.
- Book values normally ignores intangible assets fair value.
- Book values represent historical values. The current fair value of the assets could be much different from the balances in the balance sheet as explained above.
- Future growth potential in earnings is also not considered in the book values.
In the light of above, the book values are just an accounting figure. Even a market to book value ratio just greater than 1 may not mean overvaluation. It may undervaluation of the business. It may possibly be worth 10 times the book value. For example, Apple has this ratio ranging around 9 in Oct’ 2018 and Amazon ranging around 20.
Before taking any decision based on this ratio, we recommend comparing this ratio with that of other industry peers of that corporation. Also, recommend using other financial analysis ratios along with it.
Like any other financial metrics, market to book ratio also suffered from some limitations. The primary issue is that it ignores the intangible assets of a company like goodwill, brand equity, patent etc. In today’s business world, it is well accepted that intangible assets have got real values. There are ways and means of bringing them to balance sheet also but not necessarily every corporation has already done it. It also ignores the prospective earnings growth of a business.
Therefore, this ratio is seldom meaningful where a corporation has majorly intangible assets like software, know-how or knowledge-based companies etc.
This ratio is primarily useful for existing and prospective investors simply because it will be of their interest to know whether the company is under or overvalued. It is best suited for valuing a company in the field of insurance, finance, real estate investment trust etc.
Price to Book Ratio
Price to Book Ratio is just another name for the market to book ratio. There is no difference between the ratios in terms of their formula to their analysis and interpretation.12