Another interesting variable, or ratio, you can look at while evaluating companies in the mutual fund portfolio is Price to Book, or P/B ratio. This ratio can be used along with P/E and PEG ratios.

Hunting gems
P/B ratio is a really interesting instrument to look for value stocks, or stocks that the market passed by without noticing them, in other words, it’s a tool for hunting gems in the sea. Such value stocks are “sitting” quietly in their holes until a special moment when they suddenly pop up from nowhere and create a small buzz that contributes to a sudden price upward drive.

P/B ratio
P/B ratio ratio is not a simple formula; you take current stock price and divide it by the book value per share. Now, the book value per share is something very similar to the company earnings per share, and relates the amount of capital, the shareholders invested into that particular stock, to the number of shares held by those investors (Average Outstanding Shares). That capital is the difference between the total amount of company assets and its liabilities. That capital is also called Stockholders’ Equity. Very confusing, and you wont be able to grasp it without a shot of tequila

A simple and sweet explanation of P/B: this ratio shows you the difference between the current market price and the semi-potential price that calculated based on the company’s behavior/assets. If the potential price is smaller then the market value - the stock is overpriced, and has no potential value for you as an investor.

Let’s look at the formulas:

• Stockholders’ Equity = Total Assets - Total Liabilities
• Book Value Per Share = (Stockholders’ Equity - Preferred Stock) / Average Outstanding Shares
• P/B ratio = Share Price / Book Value Per Share

Did you notice something like Preferred Stock above? The Preferred Stock is an interesting value. It’s amount of privileged stock shares, this “special” shares have some additional rights that are listed on the Wikipedia. Such stocks are sold only to cool guys, and, for example, may return very good dividends.

Life is not that easy
The complicated P/B formula also offers the complicated conclusions over the results. In general, low P/B ratio shows good value for the investment, thus the stock market price is below it’s real value (undervalued stock). And relatively high P/B ratio shows an overpriced stock. A P/B ratio below 1 is considered low and deserves some attention from you.

However, do not relax yet, everything is not that simple. When some conditions apply, a very low P/B ratio (below 1 and very close to zero) may show that company is not healthy and something wrong is going on with it’s balance sheet (for example, company is overstated the real amount of Total Assets to get your invested money and take off in Mexico). Read all the news about the company, check if the company produces free cash flow (you can check it on the Yahoo Finance). If company produces only services and not goods (like software, money, food and other products), be very careful and pay attention to strange news like changes in management staff, etc.

In some cases, an entire industry sector may just have a low average P/B, so the companies in such may have very low P/B, and it’s fine.

Size Matters
When you consider to use P/B ratio, consider the size of a company, otherwise this ratio may not show the real state of things. The explanation can be seen from the formulas above - this ratio is depending on big amount of cash flow (assets, liabilities, amount of stock shares on the market), thus smaller companies will not reveal themselves… Thus, a big company with huge cash flow like manufacturing companies, banks, etc. will have a very stable P/B ratio showing the real deal.

Conclusion
If a company stock price is less than its book value (or has a P/B less than 1), it will tell you one of two things: either the rest of the investors believe the stock is overpriced (huh, you are smarter then the rest of those guys and gals, and you’ve found a gem you can resell for a big buck), or the company earnings are very poor (returns are negative). Do some research in the news from the company, and if the former is true stay away from that company, do not be even tempted to buy it.

If you are asking yourself where you can find P/B ratio, Yahoo Finance is you best friend. Just look up the quote of the company and head to the “Key Statistics” on the left sidebar; on the statistics page, find a box with “VALUATION MEASURES” header, and then in the line named “Price/Book (mrq):” will be the value you need.

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