In this article, we’re going to explore the Market to Book Ratio (aka Market to Book Multiple).
For this particular Multiple, we need to know a little bit of accounting.
So let’s just have a quick recap of some accounting fundamentals.
Accounting Fundamentals Recap
Recall that the Accounting Equation is:
Strictly, that’s Total Assets, and Total Liabilities.
Assets are things we own.
Liabilities are things we owe.
And Equity is our net worth, in a sense.
It’s net-worth “in a sense” because it refers to the net worth in an accounting aka “book value” / “net assets” context.
Because of the way accounting works, the values that you see on a Balance Sheet for instance, are not necessarily representative of the economic reality.
That’s ultimately because of things like the principle of accruals and historic cost accounting, for example.
Tangible vs. Intangible Asset
The other important concept you need to know is the difference between:
- Tangible asset, and
- Intangible asset
A tangible asset is an asset you can touch. Think buildings, vehicles, computers, etc.
An intangible asset on the other hand, is an asset you cannot touch. Software, trademarks, patents, are all examples of intangible assets.
What is the Market to Book Ratio?
Now, if we think about the Market to Book Ratio (MTB), it shows you the market value for stock relative to its book value.
In other words…
The Market to Book is a financial ratio compares the economic value / of a company with its accounting value.
You can also think of the Market to Book Ratio as a valuation ratio. Because for instance, you could use a Multiples Valuation approach to estimate the value of a company / share using the MTB ratio.
This Article features a concept that is covered extensively in our course on Stock Valuation (using Multiples).
If you’re interested in learning and mastering Stock Valuation (using Multiples), then you should definitely check out the course.
Calculating the MTB
It’s calculated as the ratio of the current market price and “BVPS” or book value per share, like this…
Where refers to the current market price of 1 share of a company, and refers to the book value of 1 share of that company.
The (or book value per share) is calculated by taking the Total Equity (from the Balance Sheet) and dividing it by the Number of Shares. In other words, it’s…
Importantly, because accountants love jargon, there are loads of other terms for total equity, including:
- Net Assets,
- Net Asset Value
- Ownership Interest,
- Owner’s Equity
All of these refer to exactly the same thing.
And given that the book value per share is total equity divided by number of shares, just like we could express the Price to Earnings / Price Earnings Ratio and Price to Sales Ratio at the firm level, we can do exactly the same thing with the Market to Book ratio as well.
Alternative Expression for the MTB
We can write it like this…
Why? Because it’s essentially identical to the “standard” equation, where we divide by .
So here’s the “standard” equation again…
Given the expression for , we can rewrite the equation for as…
Which can then be rewritten like so…
And that in turn can be rewritten like so…
Now, multiplying the Price by the Number of Shares gives us the Market Capitalization, meaning our equation becomes…
So with a little bit of rearranging, following exactly the same approach we took for the Price to Earnings and Price to Sales multiples in sister article posts, we can express the market to book ratio at the firm level.
Okay, that’s how we calculate it. But what’s more important is how we interpret it.
Interpreting the Market to Book Ratio
There’s broadly 2 ways of interpreting the Market to Book (MTB), including seeing it as a proxy for:
- determining whether a stock is under or overvalues, or
- identifying whether a stock is a “growth” or “value” stock
Undervalued vs. Overvalued
Some people see the Market to Book ratio as a determinant of whether a stock is under or overvalued.
The problem with this is that, as we said earlier in this post, accounting doesn’t really reflect the economic reality.
And so when you look at a Book Value of Equity, and compare that to the Market Price of the stock, you can’t – and certainly shouldn’t – conclude that the stock is under or overvalued.
Want to go beyond the MTB?
Get the Stock Valuation (using Multiples) Study Pack (for FREE!).
Growth vs. Value
An alternative interpretation sees the Market to Book ratio as a proxy for determining if a stock is a growth stock or a value stock.
This interpretation is particularly useful for the value investor who is interested in value investing.
Now, growth stocks are just stocks that we expect to have a reasonably high level of growth.
And value stocks are those that are considered to be a sort of “good bargain”, or good “value for money”.
Generally speaking, value stocks tend to have a that is lower than 1.
And that’s because the Market Capitalization of these stocks is lower than the Book Value.
Thus, in a sense, you’re getting a sort of “bargain” because the price that you pay – the market price – is lesser than the book value, which is what it’s worth as far as the financial statements go.
But again, given that accounting doesn’t necessarily reflect the economic reality, this is strictly not true.
Just because you buy a stock that has doesn’t mean that you’ve really got a bargain.
On another note, stocks whose market to book ratio is greater than 1 tend to be seen as growth stocks.
And that’s ultimately because investors are paying more than what it’s worth in the expectation of growth.
But again, strictly speaking, we can’t really say that you’re paying more.
Because accounting just doesn’t reflect the economic reality!
But in a somewhat ambiguous sense, you’re paying more than what the financial statements suggest the stock is worth.
And the only reason you would really do so is because you’re sort of “betting on the future”.
Proxy for Growth?
So this sort of interpretation is actually quite similar to what we talked about when we looked at the price to earnings ratio as a proxy for growth.
Now, importantly, if we think about why some firms have higher market to book ratios…
So why some stocks have and why others have a …
Ultimately, firms with high unaccountable intangible assets will tend to have high Market to Book ratios.
These are firms that have, for instance, valuable customer lists. Or really great user experiences, and user interface designs. And perhaps something like automated business processes. Or indeed, have really talented people working for them.
Unfortunately, accounting does not capture any of these incredibly valuable assets.
As far as the business interpretation or perception goes, accounting tends to be focused on things that can be “reliably measured”.
And unfortunately, valuing an like “really talented people” or “valuable customer lists” has a relatively high level of subjectivity involved.
That is why accounting doesn’t tend to consider these items as a .
Thus, naturally, they don’t show up in the financial statements; which means that the book values do not reflect the value of these assets.
However, the market price will reflect these assets in one way or another.
And so naturally, the market price will be greater than the book value.
Which is why some firms end up with a higher market to book ratio.
Equally of course, if we think about the other type of firms – those with low market-to-books – these tend to be firms that have high tangibles or a large amount of tangible assets.
Examples of tangling assets include property, plant equipment; or vehicles; essentially, things that you can touch and see.
Firms with low Book to Market ratios probably have fewer unaccountable intangible assets, such as the things we just talked about earlier.
Essentially then, firms that have a lot of assets that can be accounted for, will have book values that better reflect the economic reality. Compared to say, firms that have assets that can’t be accounted for.
Naturally then, if the assets can be accounted for, then the book values will show it. As a result, the book values will tend to be closer to the market price or the economic reality.
Accounting conventions and ambiguities mean that the interpretation of the market to book ratio – fortunately or unfortunately – is not quite as “black and white” as we would like.
There is quite a lot of gray as far as interpreting the Market to Book ratio goes.
In summary, we learned that the Market to Book (or MTB) shows you the market value of a stock relative to its book value.
We saw that it’s calculated as…
Where is the market price of the stock. And is the book value per share, which in turn is nothing but the Total Equity divided by the Number of Shares.
Perhaps most importantly, we learned that the market to book can be seen as a proxy for identifying growth versus value stocks. Or it can be seen as a ratio to identify undervalued versus overvalued stocks.
It’s important to note that this interpretation is not free from flaws. Because ultimately, accounting does not necessarily reflect the economic reality.
Thus, to conclude whether a stock is under or overvalued by comparing the market price with a price that doesn’t reflect the economic reality is, well, fundamentally flawed!
Do you want to build your own robust stock valuation system?