The market to book financial ratio, also called the price to book ratio, measures the market value of a company relative to its book or accounting value.
Book Value vs. Market Value
The market value of the company is its value at any point in time as determined by the financial marketplace and is simply the product of the share price times the total number of shares outstanding.
The book value, in contrast, is the net asset value of the company — its total tangible assets (such as property and machinery) minus depreciation minus liabilities:
Book Value = Net Asset Value
Net Asset Value = Tangible Assets - Depreciation Liabilities
Note that intangible assets, such as a company's patents, are not included in book value. The omission of intangible assets in the calculation of Net Asset Value is an accounting necessity because it's usually the case that while a tangible asset's current value can be easily tracked by determining its original cost, then subtracting depreciation, an intangible asset's current value may be a matter of opinion or difficult to determine. "Goodwill" for instance, is an intangible asset that a proud business owner may believe to be quite valuable while a banker may note that it only has as much value as the general health of the business determines. If the business is failing, goodwill value may eventually fall to zero.
Market to Book Financial Ratio
The market to book financial ratio equals the market value of the company divided by its book value:
Market to Book Financial Ratio = Market Value ÷ Book Value
Normally, a company's share value will be greater than its book value because the share price takes into account investors' estimate of the profitability of the company — how well it uses its assets — and includes best guesses of the future value of the company. The book value, on the other hand, makes no estimation of how well the company uses its assets to drive earnings and does not take into account revenue growth or any of the other financial parameters that take into account future earnings.
How the Market to Book Ratio Is Used
Security analysts and investors look at the market to book ratio as one indication of worth. The book value is not quite the same thing as the company's liquidation value — what stockholders might recover in the event of a bankruptcy — but it comes a lot closer than market value to assessing the worst-case value of the company.
The book value can still be a poor gauge of a company's worth if analyzed in a vacuum as it takes no account of the significance of earnings growth (or its lack thereof), and it leaves certain assets, such as the patents held by the company out of the equation. Because assets like patents are intangible rather than tangible assets, they are not included in book value. But for certain companies — pharmaceuticals are one obvious example — their patents may be the company's most valuable assets.
Despite these limitations, comparing the market to book ratios of companies in the same market sector can provide valuable insights into how the market assesses one company in comparison to its competitors. The market price to book ratio of a company that far exceeds its competitors may be overvalued. On the other hand, it may reflect a company's history of superior earnings growth and the confidence that investors place in its ability to continue to outperform its competitors.