Investors and analysts will normally deploy one particular market base accounting ratio which is the Market to Book ratio or Price-to-Book Value Ratio.
This ratio expresses the relationship between a company’s value in the stock market and the net asset value as per the company’s balance sheet.
The formula is = market price per share/book value per share.
The purpose of this ratio is to indicate the value investors place on the company. To a certain extent, this ratio can reflects that the company’s assets are undervalued.
Simple illustration:
In 2006, Company A’s market price per share =$2.20
The book value of its share was $2.00
It’s market/book ratio
=$2.20/$2.00 =1.10
which means that the company’s value in the market place is 10% higher than its actual book value.
So what might this ratio reveals:
- it might indicates that the company’s assets are understated/undervalued and
- its prospects are good and investors believe that its earnings and value would grow
The market/book ratio summarizes investors’ views on the company’s performance and its future prospects. This is done when the investors decide the rate(price) for a business and they mark the share price at a premium or discount depending on whether the return is more or less.
More salient points:
- A higher price-to-book ratio or market to book ratio is more desirable since it shows that the stock maret places a high value on the company. In some business like the banks, the book value per share may be higher than the market price per share
- If investors believe that the market price of a company is too high relative to its book value, they may sell the stock; alternatively if they feel that the stock is undervalued in the market, investors will be encouraged to buy stock.
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