Does a High Price-To-Book Ratio Correlate to ROE?

Price-to-book (P/B) is an equity valuation ratio that compares market value (stock price per share) to book value (equity of shareholders). P/B is expressed as a multiple – how many times book value stock investors are willing to pay to acquire a company’s stock. Book value is a calculation of the company’s recorded assets minus the liabilities shown on its balance sheet – a per-share estimate of the liquidation value of the company.

How a High P/B Ratio Correlates to High ROE

A high P/B ratio doesn’t necessarily correspond to a high return on equity (ROE), but it does under ideal circumstances.

The straightforward calculation of P/B is:

P/B ratio = Stock price / Shareholders’ equity per share

The per-share equity figure is arrived at by looking at the company’s most recent balance sheet and dividing shareholders’ equity by the number of outstanding shares.

Meanwhile, ROE is a metric of profit efficiency, an equity valuation that measures profitability as a function of the amount of capital invested by stockholders. This metric provides a percentage assessment of the return on that equity investment.

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder’s Equity

It’s useful to consider P/B ratio evaluation along with ROE evaluation. Neither valuation tool is flawless, so it’s helpful to check one valuation against another. P/B and ROE evaluate a stock from different viewpoints, but they are related; they both factor in the book value of equity.

What to Watch for in the Data

A high P/B ratio stock commonly has a correspondingly-high ROE since investors are inclined to pay higher multiples of book value for a stock that is showing them a good return. Companies with high growth rates are likely to have high P/B ratios.

Any sizable divergence between the two measures, for example a high P/B with a low ROE, can be a warning signal that shareholder equity is no longer increasing.

A wise approach for evaluating may be to combine the measures instead, such as P/B and ROE, to examine trends of the figures over a period of years.

Source: Read Full Article