Book To Market Ratio

Last Updated :

21 Aug, 2024

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Table Of Contents

What Is Book To Market Ratio?

The Book to Market ratio compares the book value of equity with the market capitalization, where the book value is the accounting value of shareholders' equity. It is computed by dividing the current book value of equity by the market value. In contrast, market capitalization is determined based on the price at which the stock is traded.

It is always recommended to use other fundamental variables while interpreting a ratio. These fundamental variables could be growth rate, return on equity, payout ratio, or the expected risk in the company. To a large extent, any changes in these fundamental variables will explain the ratio and must be considered while concluding if the stock is undervalued or overvalued.

What Is Book To Market Ratio?

The book-to-market ratio is derived by dividing a stock's current book equity value by its market value and comparing the accounting value of equity to its trading price.
This ratio is a valuable tool for evaluating equity. It can be used to compare the market value of equity with earnings or book value, which encompasses historical data like retained earnings and paid-in capital.
The book-to-market ratio is particularly beneficial for companies with intangible assets. It is well-suited for those with tangible assets such as insurance, banking, and real estate investment trusts (REITs).

Book To Market Ratio Explained

The book to market ratio is an equity multiple. Equity multiple generally requires two inputs- the market value of equity and a variable to which it is scaled (earnings, book value, or revenues). As the name suggests, the variable to which this book to market ratio growth stock is scaled is the book value of equity.

The book value of equity, also known as the shareholders’ equity, includes the retained earnings and any other accounting adjustments made to book equity along with the paid-in capital. Book value is based on accounting conventions and is historic.

The market value of equity, on the other hand, reflects the market’s expectations of the company’s earning power and cash flows and is determined by multiplying the current stock price by the total number of outstanding shares. The current stock price is readily available from the exchange on which it is traded.

The low or high book to market ratio gives a fair idea of whether the common stock of the company is undervalued or overvalued. A ratio of less than 1 (ratio < 1) can be interpreted as the stock being overvalued, while a ratio greater than 1 (ratio > 1) can be interpreted as the stock being undervalued. However, this is only a simple analysis and is not recommended (in isolation) since the fair value should also account for future expectations, which this ratio fails to consider.

Formula

This positive or negative book to market ratio is not meaningful when subject companies have huge internally-generated intangibles such as brands, customer relationships, etc., which do not reflect the book value. It is hence, best suited for companies with real assets in books such as insurance, banking, REITs, etc. Hence, while making any investment decisions, it is essential to consider other ratios and the underlying fundamental variables.

However, let us try to understand the formula that is commonly used to make the calculation of low or high book to market ratio. It is as given below:

Book to Market Ratio = Book Value of Equity / Market Value of Equity

where,

Book value of equity = Based on accounting conventions
The market value of equity = Market capitalization (Price * number of shares outstanding)

Example

Let us understand the concept of book to market ratio growth stock with the help of a suitable example.

XYZ Inc., a Nasdaq-listed company, is currently trading at $11.25 per share. The firm had a book value of assets of $110 million and a book value of liabilities of $65 million at the end of 2019. Based on the recent filing with the exchange and the SEC, the company has 4 million shares outstanding. As an analyst, determine of low or high book to market ratio for XYZ and, assuming everything is constant, interpret how the ratio influences investment decisions.

Solution

Use the below-given data for the calculation of positive or negative book to market ratio.

Particulars	US ($)
Book Value of Assets	110000000
Book Value of Liabilities	65000000
Price Per Share	11.25
Number of Shares Outstanding	4000000

Calculation of Book & Market Value of Equity

= 110000000-65000000
Book Value of Equity = 45000000
= 11.25* 4000000
Market Value of Equity = 45000000

The calculation can be done as follows,

=45000000/45000000
Book Value of Equity = 1.00

When a stock price falls to $10 -

=45000000/40000000
Book Value of Equity = 1.13

Calculation when a stock price increases to $20 can be done as follows,

=45000000/80000000
Book Value of Equity = 0.56

Interpretation

In the original scenario, the stocks with high book to market ratio shows that the stock is fairly priced since the investors are willing to pay exactly what the net assets in the company are worth. If the stock price falls to $10 per share, the ratio increases to 1.13, which undervalues the stock, and other things stay constant. It is important to note that the book value of equity stays constant.
The investors value the company at $40 million, while its net assets are worth $45 million. But it is not necessary that the stock is undervalued, and one should not jump to this conclusion. The market value is sensitive to investor expectations concerning future growth, company risk, expected payouts, etc. A lower growth expectation with low payouts or increased risk could justify this multiple.
The investors value its net assets at $80 million, while its net assets are worth $45 million. If the stock price increases to $20 per share, the stocks with high book to market ratio falls to 0.56, overvaluing the stock. Other things stay constant.
Usually, investors interpret this as a potential sign of correction with the price coming down, which again is sensitive to investor expectations concerning the fundamental variables. A higher growth expectation, a decrease in risk, and a higher expected payout ratio could justify this multiple and decrease the chances of a potential correction.
Further, the book value is never readily available. For example, if an investor wanted the ratio on February 1, 2020, the latest book value for this date will not be available if this is not the end of a quarter of the financial year for the company. Another reason which renders this ratio to be less reliable in respect to how book value is determined. The book value normally ignores the fair value of intangible assets and the growth potential in the earnings, which leads to the risk of estimating a lower book value and hence, the ratio.

Frequently Asked Questions (FAQs)

1. What is a good book-to-market ratio?

A good book-to-market ratio depends on the context and industry. In general, a book-to-market ratio below 1 indicates that a company's market value is higher than its accounting value (book value), which may suggest that the market has high expectations for its growth potential. On the other hand, a book-to-market ratio above 1 suggests the market values the company lower than its book value, indicating potential undervaluation.

2. What is the importance of the book-to-the-market ratio?

The book-to-market ratio is important as it provides insights into a company's valuation and market perception. It helps investors identify potential undervalued or overvalued stocks. Companies with a high book-to-market ratio may be considered value investments, attracting investors looking for potentially undervalued opportunities. Conversely, low book-to-market ratio companies may be considered growth investments, appealing to investors seeking companies with high growth prospects.

3. What are the applications of the book-to-market ratio?

The book-to-market ratio finds various applications in finance and investing. It is used as a fundamental valuation metric to identify value or growth investment opportunities. A high book-to-market ratio may suggest a value investment, while a low ratio may indicate a growth investment. The ratio is also used in academic research and quantitative investment strategies, such as value investing, to screen and select stocks with specific characteristics.