What is Book to Market Ratio?
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 while the market capitalization is determined based on the price at which the stock is traded. It is computed by dividing the current book value of equity by the market value of equity.
Explanation
The book to market ratio is 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 ratio is scaled is the book value of equity.
The book value of equity, also known as the shareholders’ equity, includes the retained earnings of the business and any other accounting adjustments made to book equity along with the paid-in capital. Book value is based on the accounting conventions and is historic in nature.
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 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 the future expectations which this ratio fails to consider.
Book to Market Ratio Formula
where,
- Book value of equity = Based on accounting conventions
- The market value of equity = Market capitalization (Price * number of shares outstanding)
Example of Book to Market Ratio
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 the Book-to-Market ratio for XYZ and assuming everything constant interprets how the ratio influences investment decisions.
Solution
Use the below-given data for calculation of book to market ratio.
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 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, other things staying constant. It is important to note that the book value of equity stays constant.
It is very clear that the investors are valuing the company at $40 million while its net assets are actually 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 with respect to future growth, company risk, expected payouts and etc. A lower growth expectation with low payouts or increased risk could justify this multiple.
If the stock price increases to $20 per share the ratio fall to 0.56 which overvalues the stock, other things staying constant. The investors are valuing the net assets in the company at $80 million while its net assets are actually worth $45 million.
Usually, investors interpret this as a potential sign of correction with the price coming down which again is sensitive to investor expectations with respect to 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.
Conclusion
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.
Further, the book value is never readily available. For example, if an investor wants the ratio on February 1, 2020, the latest book value for this date will not available if this not the end of a quarter of the financial year for the company.
Another reason which renders this ratio to be less reliable is with 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. Therefore, this ratio is not meaningful when subject companies have huge internally-generated intangibles such as brands, customer relationships etc. which do not reflect in 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 important to consider other ratios along with the underlying fundamental variables.
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