What is price to book ratio & how it helps you select equity stocks

What is price to book ratio (For Banks & NBFC)

Price-to-Book (PB) ratio is one of the most popular valuation ratios commonly used for evaluating banks and Non-Banking Finance Companies (NBFCs).

But what is price to book ratio exactly?

P/E ratio tells you how much price investors are willing to pay for every rupee earned by a bank. Similarly, P/B ratio shows what price investors are willing to pay over and above the net worth of a bank. For instance, a P/B ratio of 3 suggests that investors are willing to pay as much as 3 times the bank’s net worth.

In the case of financial companies having a lending business, it’s crucial to check P/B ratio because more than just profit, the net worth matters a lot to remain solvent and be in the business.

How to evaluate price to book ratio?

Nowadays, you get P/B ratios readily available but if you still want to calculate manually, here’s the formula.

Price-to-Book (PB)= Market capitalisation/ Net worth

Where,

Net worth = share capital + reserves and surplus; or to be more precise, total assets- total liabilities.

Alternatively, you can use the following formula as well.

PB= Price per share/Book value per share

In this case, the additional step is required to calculate the book value per share—net worth / number of shares outstanding.

Now let’s check out P/B ratios of some popular banks and NBFCs operating in India.

Now many of you might be keen to know how to extract the net worth of a bank or an NBFC. Let’s take a quick example.

Check the highlighted rows in Table 2 and Table 3. When you reduce total assets by the amount of deposits, borrowings, subordinated debt and other liabilities, what you get is the net worth of ICICI Bank as of March 31, 2022. Alternatively, you can simply add up equity share capital and reserves to find the book value of the Bank.

At the end of FY22, the ICICI Bank’s net worth was Rs 1,705 billion or (Rs 1.7 lakh crore).

 Connecting the dots—price appreciation vs. book value appreciation

Now refer to Table 1 to find the net worth of ICICI Bank at the end of FY23. It has shot up to Rs 2.14 lakh crore—a 26% jump. Interestingly, the stock of ICICI Bank has appreciated nearly 20% in FY23. This goes to show that ICICI Bank continued to get almost the same P/B multiples it enjoyed in FY22. In other words, the stock price appreciation is justified by a considerable rise in its net worth.

What can you infer from P/B ratio and how it can help you pick financial stocks?

Investors and market experts have diverse views on what one should infer from P/B.

One school of thought believes any banking and NBFC stock trading below or near its book value is cheap (and thus attractive). In contrast, a bank or an NBFC trading at a higher P/B multiple is expensive and even overvalued in extreme cases (thus should be avoided).

While the other camp advocates exactly the opposite. Experts from this side, who don’t buy the argument that a bank or an NBFC trading below its book value is cheap, cite reasons for it being cheap.  According to them, high P/B stocks often hint at better utilisation of funds, higher profitability, robust capital structure and better asset quality.

Both these approaches have their merits. Hence, investors would be better off retaining the best of both worlds.

Using P/B ratio in stock evaluation process effectively:

• Check out P/B ratios of all banking stocks
• See the multiples the industry leader is getting at the moment
• Whenever the industry leader trades below its long period averages (or near its book value); it is far better to go with the leader and avoid getting into a possible value trap (of buying low P/B stocks). For instance, at the beginning of coronavirus pandemic, frontline banking stocks were available at throwaway valuations. It was wise to stay with the industry leaders then.
• However, when you see a major turnaround in the asset quality or quality of operations/management of a bank, accumulating low P/B stocks may potentially offer you a big upside—like Public Sector Banks, PSBs, did in 2021 and 2022.

In a nutshell

P/B ratio is quit handy when it comes to evaluation of a banking stock.  However, relying merely on P/B ratio would be an oversimplified approach. Use it in conjunction with other parameters of sound stock selection to make the most of it.