The price-to-book ratio is used by companies to compare their market to book value. On the other hand, price-to-sales ratio is used by firms to compare their stock prices to revenues. Both these ratios are crucial when analyzing the financial health of the business. Thus, below we have illustrated with examples, formulas and their application, the importance of these ratios.
What is Price to Book Ratio?
Price to book (P/B) ratio compares the market value of a stock to its book value. It can be arrived at by dividing the stock’s current closing price by last quarter’s book value of that stock. It is also called ‘price equity ratio’. A lower value of P/B ratio generally signifies that the stock is undervalued; however it may also mean that the company is having some fundamental problems. Like most of the ratios (especially stock related), P/B ratio also varies with industry.
NOTE: When looking for funds for business from investors, this ratio can help calculate value of stock, and ease in forming a business plan to convince the sponsors.
The value addition caused to the company’s equity by the market participants is reflected through the P/B ratio. Market value of a stock is forward looking component which usually reflects the possible trends in future cash flows of the company. The book value of a stock is basically historically based which reflects the issuance, augmentation by any profits or losses, and reduction by dividends or buybacks.
- Differences between the Market and Book Value of Equity
The market value of stock is generally higher than the book value which is due to the reason of application of certain accounting principles on treatment of specific costs, which makes P/B ratio greater than 1. The ratio goes below one under extreme circumstances of financial distress, bankruptcy, etc. Unless acquired from others, accounting principles do not recognize brand value and other intangible assets and hence all the costs pertaining to creation of intangible assets are expensed immediately.
- Advantages and Disadvantages of the P/B Ratio
Due to the reason that book value is an intuitive and stable metric to be compared with the market value, P/B ratio is found useful by the investors for taking investment decisions. P/B ratio is a better measure than P/E ratio as companies may usually have a negative earning which makes the P/E ratio useless but there are fewer chances that any company has negative book value of a stock.
When accounting standards applied are not same (mostly in the cases of different countries) the P/B ratio may not be comparable. The ratio may also not be useful to companies having fewer tangible assets in their balance sheets, for example, services and IT companies.
What is Price to Sales Ratio?
Price to Sales ratio is a valuation ratio that establishes a relation and compares stock price of company to its revenues. It acts as an indicator of value placed per rupee sales/ revenue of the company. It can be calculated in two ways; first is by dividing market capitalization of company by 12 month sale or second on the basis of per share, by dividing stock price by sales per share over a period of 12 months.
This ratio is also known as ‘sales multiple’ or ‘revenue multiple’ and is abbreviated as P/S ratio or PSR ratio. Just like other ratios, it is best suitable to compare companies in the same sector. A low PSR ratio may possibly be indicative of undervaluation and a higher one depicts overvaluation.
The 12 month period (past four quarters) the sales of which are used for calculation of PRS ratio is called trailing 12 months, however the PSR ratio which is prepared on a forecast basis is called forward ratio.
Let us take an example. The sales for fiscal year 1 (FY1) are actual sales and sales for FY2 are analysts’ average forecasts (suppose that we are in Q1 of FY2). The company has 10 crore shares outstanding, with the shares presently trading at Rs 10. Also, sales per quarter are as follows (in crores): FY1 Q1 10, FY1 Q2 11, FY1 Q3 12, FY1 Q4 12.5, FY2 Q1 13, FY2 Q2 13.5, FY2 Q3 13, and FY2 Q4 12.5.
Currently, its ratio on a trailing 12-month basis shall be calculated as given below –
- Sales for past 12 months (ttm) = Rs 45.5 crore (sum of all FY1 values)
- Sales per share (ttm) = Rs 4.55
- P/S ratio = Rs 10/ Rs 4.55 = 2.20
The company’s P/S ratio for the present fiscal year to be calculated as given below –
- Sales for current fiscal year (FY2) = Rs 52 crore
- Sales per share = Rs 5.20
- P/S ratio = Rs 10/ Rs 5.20 = 1.92
If any peer company in the same sector with similar size in terms of market capitalization is trading at PRS of 1.5 suggests a premium valuation with 2.2 of this company.
Both price-to-book ratio and price-to-sales ratio assesses the credibility and financial health of the company in unique ways. By going through the above-given post, you will be able to use the ratios in a suitable manner for your business.