The market-to-book ratio, also called the price book ratio, shows the market value of the company relative to its accounting (book) value.
In general, the book value of assets is below the market value of assets, since some assets may not be on the balance sheet (not recognized). When assets are recognized, but historic cost is used as the basis for valuation, the assets may be undervalued.
On the other hand, the book value of liabilities is generally close to the market value of liabilities.
Market to Book Ratio Example
Differences between the market value of a liability and the book value of equity are a result of (1) the term, as liabilities within one year are normally valued at book, whereas liabilities due after one year are valued at the present value (2) the difference between the market interest rate and the effective interest rate and (3) the probability of default, which is priced in the market value but not in the book value.
More details on this issue are included in the section on bonds in liabilities.
As assets are normally undervalued to a greater extent than liabilities, equity (the residual claim: assets minus liabilities) will be undervalued relative to the market value of equity as well. A ratio that makes the undervaluation comparable across firms is the market-to-book ratio, where the market capitalization (total market value) is divided by book value of equity (the accounting value of the company). This ratio differs across industries, as the following chart shows.
Market-to-book ratio by industry
For $1 of equity, the median stock price for firms in the utilities industry is $1.50. For pharmaceutical firms, investors are willing to pay $3.70 for $1 of equity. Note that for each industry the market-to-book ratio is above 1, in other words, for the median firm in each industry, the accounting value of the firm is lower than the market capitalization.
Price Book Ratio Explained
– the balance sheet shows the financial position at a point in time (a financial ‘snapshot’)
– the accounting equation states that the value of the resources (assets) always equals total funding of these assets (liabilities and equity)
– it is not possible to infer a firm’s profitability from (the) balance sheet(s)
– assets are usually understated relative to the market value, whereas liabilities are not (or to a lesser extent), as a result, equity is usually understated (as equity is defined as the difference between the understated assets and total liabilities)