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 equityBook Value Of EquityThe book value of equity reflects the fund that belongs to the equity shareholders and is available for distribution to the shareholders. It is computed as the net amount remaining after deducting all of the company's liabilities from its total assets.read more.
- The book value of equity, also known as the shareholders’ equity, includes the retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more 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 conventionsAccounting ConventionsAccounting conventions are specific guidelines for complicated and unclear business transactions, not compulsory or legally binding, but these generally accepted principles maintain consistency in financial statements. These conventions help in standardizing the financial reporting process, disclosure of transactions, and relevance.read more 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 future expectations, which this ratio fails to consider.
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For eg:
Source: Book to Market Ratio (wallstreetmojo.com)
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 $65 million at the end of 2019. Based on the recent filing with the exchange and the SEC, the company has 4 million shares outstandingShares OutstandingOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet.read more. As an analyst, determine the Book-to-Market ratio for XYZ and, assuming everything constant interprets how the ratio influences investment decisions.
Solution
Use the below-given data for calculation of book to market ratio.
| Particulars | US ($) |
|---|---|
| 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 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 assetsNet AssetsNet Fixed Assets is a financial metric used to calculate the overall value of a firm’s fixed assets. You can calculate it by deducting the total depreciation or liabilities from the total amount paid for all the fixed assets. read more 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, 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 assetsNet AssetsThe net asset on the balance sheet is the amount by which your total assets exceed your total liabilities and is calculated by simply adding what you own (assets) and subtract it from whatever you owe (liabilities). It is commonly known as net worth (NW).read more 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 equityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.read more, 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 be 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 assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. read more 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 assetsReal AssetsReal Assets are tangible assets that have an inherent value due to their physical attributes. These assets include metals, commodities, land, and factory, building, and infrastructure assets. read more in books such as insurance, banking, REITs, etc. Hence, while making any investment decisions, it is essential to consider other ratios along with the underlying fundamental variables.
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