Selecting one stock out of the pool of stocks available is a nightmare for many. Right?
But if one wishes to grow wealth then he should make sure that the returns from his portfolio should be beating inflation. On an average in past 20 years, the inflation rate has been around 7% p.a. So if you are someone who wishes to grow their wealth, it is important to have exposure of equity in the portfolio. This will be useful as equity investments beats inflation in the long run and it is tax efficient as well.
So looking at these 2 major advantages and current market situation where markets have moved up approx. 45% from lows of March 2020, if you have made up your mind to invest in equities, the next question comes where to invest your money. There are ample number of stocks available in the market. So it becomes a little difficult for a layman investor to select the best stock which gives him good returns.
An informed investor should not only look at past returns but also the risk component involved along with the fundamentals of the company.
Now there are many factors one should consider while selecting a stock. I will be addressing one such parameter that investors look at before investing into any one particular stock. I am talking about P/B ratio.
Let us understand the meaning first.
Price to book value ratio
There are many investors who look at P/B ratio to decide whether to invest in a stock or not. Are you one of them? If yes, read on to understand whether you were right or wrong?
And if you are someone who doesn’t have an idea as what is P/B ratio then also continue reading so that you could use it for your benefit.
So P/B ratio is used to compare a stock’s market value with its book value.
How it is calculated?
P/B ratio = Current Market price / Book value per share
In simple terms, Book value is nothing but Assets of the company less Liabilities.
It is important to understand the components of P/B ratio to deeply know what it reflects.
Let me take an example of Company ABC to explain:-
Market price = 300
Total shares = 60000
Assets = 1 crore
Liabilities = 40 lacs
Book value = Assets Less Liabilities = 1crore – 40 lacs = 60 lacs
Book value per share = Book value / No. of shares = 60 lacs / 60000 = 100
P/B ratio = Current Market price / Book value per share = 300/100 = 3
How to interpret P/B ratio?
In the above example, P/B ratio is 3. It means for one rupee of net asset of the company, people are ready to pay Rs.3. In other words, you are giving Rs. 300 to buy Rs.100 net asset of the company.
Many people interpret it as over valuation which implies that the stock is overvalued and thus one should not invest into such companies. You might have heard people saying that invest in a stock with a P/B ratio of less than 1. It is because of this reason they say so.
Currently, there are approx. 18 companies in BSE500 which have P/B of less than 1.
Now let us see how right it is to invest in a stock based on its P/B ratio.
P/B ratio is great way to analyse the stock but only if it is used correctly at the right place. As it’s rightly said half knowledge is always dangerous.
Although stock with low P/B ratio looks cheap to buy but instead of looking at the low price, one should analyse to find out whether there is a scope of that company to go up.
There could be many reasons for a low P/B ratio. Some of these could be a not so strong balance sheet, increasing non-performing assets, lower capital adequacy ratio or incurring losses.
It does not make sense to look at P/B ratio for all the types of companies.
Few Points to consider
- The companies who do not have much assets because they are labour intensive. There is no point of comparing the book value as assets are not much and the business model of such companies revolves around people. Eg IT companies. Their major asset is employees which is considered as an expense and not asset in books.
- The companies with depreciating assets. There are companies which have huge plant and machineries but these are depreciating assets. So in real the owners might not be able to get a value which is stated as book value in many cases.
P/B ratio will be more useful for sectors like real estate, Banks and NBFCs.
Points to consider while selecting a stock beside P/B ratio less than 1
- One should avoid companies which have high debt.
- Avoid companies which are loss making.
- One should also look at the future aspects of the company and if you feel that the future of the company is not so promising then stay away from it.
- Rule out the companies with poor growth visibility.
- Check consistency in returns and growth of the company.
Instead you should be looking at companies which are generating high cash flows and have lower debt to equity ratio. Looking at a company whose product has a longer shelf life will also assist you to select a good company stock to invest in.
So it is highly recommended that you do not fall in the trap by just looking at the P/B ratio. There are many other factors that one should look at to gauge the future prospects of the company and get benefit from the same in your decision making.