What is Book-to-Market Ratio?
When investors seek to buy stock in a company, they want to understand the value of what they’re purchasing. The price per share is only one representation of current value, and it’s ever-changing. There are a host of metrics they can use to look at value within the context of the company itself. One of the most powerful and enlightening is book-to-market value.
Book-to-market value is a comparison ratio that shows the market’s valuation of a company relative to its intrinsic value. In simpler terms: how much more or less does the market value a company relative to its balance sheet? Book-to-market ratio provides a quick look at market sentiment, to help investors further qualify their investment thesis.
Here’s a closer look at book-to-market ratio: what it means, how to calculate it and how to use it as a qualifying metric when evaluating potential stock investments. To start, let’s break down both variables in this ratio.
What is Book Value?
Book value is the value of a company’s assets, minus the value of its liabilities. It’s calculated by looking at the company’s current balance sheet. This figure represents the total amount the company would divide up among shareholders in the event of bankruptcy and liquidation. For example:
ABC Company has $500 million in tangible assets, in the form of production equipment, facilities, vehicles and other on-the-books assets. The company also has debt of $480 million in the form of short-term loans and notes. The company’s book value is $20 million ($500 million – $480 million = $20 million).
Book value is the absolute floor of a company’s valuation: what it’s worth outside of sales and revenue, based on the sum of its assets.
What is Market Value?
Market value is the price of a share, multiplied by the number of shares outstanding. To calculate market value, also called market capitalization, you need to know the current share price and the total number of available shares. For example:
ABC Company’s current share price is $10 and it has 500 million shares available. Its current market value (cap) is $5 billion. If the share price rises to $20, its market value will rise to $10 billion. If the share price falls to $5, its market value will fall to $2.5 billion.
Market value represents the potential value of a company. The more bullish investors feel about its prospects, the larger the premium they’re willing to pay to own stock. This drives up market value.
Breaking Down Book-to-Market Value
Book-to-market value juxtaposes the absolute lowest valuation of a company against the current value as decided by the market. The formula for the book-to-market ratio is as follows:
Book-to-Market Ratio = Book Value / Market Value
Investors can judge the resulting value against a figure of one (1). If the ratio is lower than one, the stock is overvalued—the market believes the company is worth more than its balance sheet. If the ratio is higher than one, the stock is undervalued and currently trades at a discount. As we’ll discuss in a moment, this strictly means over- or under-valued in a quantitative sense—one of the limitations of a book-to-market valuation.
How to Use Book-to-Market Ratio
Book-to-market ratio is a relative benchmarking tool. It’s best-used to evaluate a company from a baseline financial standpoint, then against competitors.
For example, ABC Company has a book value of $750 million and a market value of $1 billion, giving it a book-to-market ratio of 0.75. This signals that it’s overvalued. However, investors might find that the book-to-value ratio for ABC Company’s three biggest competitors in the sector is closer to 0.60. While overvalued in a vacuum, ABC Company is actually affordable by comparison.
As mentioned, book-to-market ratio strictly looks at quantitative factors. Unfortunately, this doesn’t paint a full picture of a company’s prospective value. For example, a company might have future contracts that entitle it to significant cash flows. Investors seeing this potential will willingly pay a premium today for access to those future profits, driving up market value—yet, book value will stay the same. It creates a disparity that can skew the efficacy of a book-to-market valuation.
Book-to-Market vs. Market-to-Book
That’s right: the metric goes both ways! More often called price-to-book, this metric assesses the cost of a stock vs. the liquidation value of the company. It effectively tells investors the same thing as book-to-market ratio, but in reverse. The method used to arrive at the same conclusion simply depends on which aspect of the valuation is most important to the investor. Are they looking for an undervalued company to invest in or are they qualifying the premium they’re willing to pay for market value?
A Contextual Look at Company Value
There are many ways to examine the value of a company relative to certain investment criteria. In fact, book-to-market ratio is one of the most illuminating and convenient. Using the company’s bare-bones intrinsic value as a benchmark, it helps investors determine how high or low the market values the company by comparison.
While book-to-market ratio is a useful tool for evaluating a company, it’s even more illustrative of a company’s relative value within its industry. How high or low the ratio is can shed light on prospective value, or a stock that investors might be too bullish on. Just remember that book-to-market ratio is purely quantitative and doesn’t represent the forward-looking prospects of a company: prospects that could warrant significant future value.