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What is Market to Book Ratio (M/B)?
Market to book ratio is just a comparison of market value with book value of a firm. In other words, it suggests how much investors are paying against each dollar of book value in the balance sheet. Arithmetically, it is the ratio of market to book value.
What is Market Value and Book Value?
Market value is the value derived by multiplying stock price with 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 latest available balance sheet of a company. It is as good as 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 following formula
Market to Book Ratio Formula
Market price per share / book value per share
Market capitalization / book value
Any of the above formula can be used for calculating the ratio. First formula needs per share information whereas the second one needs the total values of the elements.
Assume there is a company X whose publicly traded stock price is $20 and it has 100,000 outstanding equity shares. 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 market to book value ratio when it is less than 1 and greater than 1. If we simply analyse, it can reflect undervaluation when it is less than 1 and overvaluation when it is greater than 1.
M/B Ratio Less Than 1:
If we drill down deep, 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 company. 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.
M/B Ratio greater Than 1:
M/B greater than 1 suggests overvaluation. The overvaluation should be considered along with the facts that tangible assets are not taken into consideration while calculating the ratio and secondly future growth in earning are not considered. Before taking decision, it should be compared with the ratios of other industry peers of that company.
Like any other financial metrics, market to book ratio also suffered from some limitations. The primary issue is that it ignores the tangible 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 company has already done it. It also ignores the prospective earnings growth of business.
Therefore, this ratio is seldom meaningful where a company has majorly intangible assets like software, know-how or knowledge based companies etc.
This ratio is primary 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.
References:February 22nd, 2018